What are derivative instruments and how are they used?
DERIVATIVE INSTRUMENTS
Firms engage in transactions that subject them to specific financial risks. Most firms face risks—that is, variability of outcome—from changes in interest rates, foreign exchange rates, and commodity prices. Firms can purchase financial instruments to reduce these business risks, that is, to reduce the volatility of certain outcomes. Some of these instruments trade in relatively active markets, like marketable securities, while others have specialized terms and do not trade at all. The general term used for the types of financial instruments that firms might buy to mitigate the risks is a derivative. The accounting for derivative financial instruments follows some of the principles governing the accounting for marketable securities, with some exceptions. This section discusses the nature, use, accounting, and reporting of derivative instruments. FASB Statements 133 and 138 and IAS 39 provide accounting and disclosure guidance for derivatives.
NATURE AND USE OF DERIVATIVE INSTRUMENTS
A derivative is a financial instrument whose value changes in response to changes in an underlying observable variable, such as a stock price, an interest rate, a currency exchange rate, or a commodity price. Unlike equity securities, which have no definite settlement date, firms settle a derivative at a date that the terms of the instrument specify. Finally, a derivative requires an investment that is small, relative to the investment in a contract that is similarly exposed to changes in market factors, or requires no investment at all. An option to purchase a share of stock derives its value from movements in the market price of that stock. A commitment to purchase a certain amount of foreign currency in the future derives its value from changes in the exchange rate for that currency. Firms use derivative instruments to hedge the risks that arise from changes in interest rates, foreign exchange rates, and commodity prices. The general idea behind hedging is that changes in the fair value of the derivative instrument offset changes in the fair value of an asset or liability or changes in future cash flows, thereby neutralizing, or at least reducing, the effects of those changes.
The forward contracts and swap contracts illustrate two types of derivative instruments. Some derivative contracts contain standardized terms and trade in relatively active markets. Others contain terms tailored to suit the needs of the contracting parties and do not trade at all. The nature and complexity of derivatives vary widely.
You might also like to view...
The risk of material misstatement related to the existence of long-lived assets at Client A is considered low, while this risk at Client B is considered high. Sufficiency of evidence for testing the existence of equipment would be higher for client B
a. True b. False Indicate whether the statement is true or false
To use a company's resources for a project that does not contribute to maximizing profits is sometimes acceptable and even sometimes required under the economic model of corporate social responsibility.
Answer the following statement true (T) or false (F)
When a firm decides that a particular customer account is uncollectible, it removes that account by debiting the Allowance for Uncollectibles and crediting Accounts Receivable, Gross. This process is called writing off the account
Indicate whether the statement is true or false
Jon thought that Aubrey ____ interested in the executive assistant position
A) may be B) maybe C) may-be