Use of Derivatives among Issuers

Financial intermediaries, investors, and issuers use derivative products to increase, reduce, or alter their exposure to an underlying to achieve their financial goals. With the development of derivatives accounting, these instruments are now reported on the balance sheet at their fair market value instead of using off-balance-sheet reporting.

Use of Derivatives among Issuers

Issuers use derivatives to primarily hedge market-based underlying exposures. Issuers often use hedge accounting, which allows them to offset a hedging instrument – such as derivatives – against a hedged transaction or balance sheet item to decrease financial statement volatility.

In other words, hedge accounting allows issuers to recognize derivative gains, losses, and associated underlying hedged transactions. According to derivative accounting standards, any derivative bought or sold must be marked to market via the income statement through earnings unless it is embedded in an asset or liability or qualifies for hedge accounting.

Types of Hedge Accounting

1. Cash Flow Hedges

Cash flow hedges absorb variable cash flow of floating-rate assets or liabilities such as interest rates and foreign exchanges. Cash flow hedges use either forward commitments or contingent claims. For example, a currency forward contract to hedge estimated future sales.

2. Fair Value Hedge

A fair value hedge occurs when a derivative is used to offset fluctuation in the fair value of an asset or liability. For example, commodities futures may be used to hedge an inventory.

3. Net Investment Hedges

Net investment hedges arise when a foreign currency bond or a derivative such as forward is used to offset the exchange rate risk of equity of a foreign operation. Using a currency forward, in this case, could be an effective way to offset foreign exchange risk associated with equity in a foreign company.

Use of Derivatives among Investors

Investors use derivatives to:

i. Replicate a Cash Market Strategy

A derivative market has greater liquidity and reduced capital requirements to trade. This feature allows investors to replicate a chosen position using derivatives easily.

ii. Perform Derivative Hedges

Derivative hedges allow an investor to isolate specific underlying exposures while retaining other positions.

iii. Add or Modify Exposures

Derivative markets are associated with the flexibility to take positions. As such, an investor can use a derivative to add or modify an exposure beyond cash market alternatives.

Note that investors are less concerned about hedge accounting treatment than issuers. This is because an investment fund’s position is usually marked to market daily and included in the daily net asset value (NAV) of the portfolio or fund. This explains why investors transact more frequently in exchange-traded derivatives markets than issuers.

Question

Derivatives intended to withstand a company’s fluctuating cash flows are most likely referred to as:

A. cash flow hedges.

B. fair value hedges.

C. new investment hedges.

Solution

The correct answer is A.

Cash flow hedges are derivatives intended to withstand a company’s fluctuating cash flows.

Fair value hedges are derivatives considered to balance off the variation in the fair value of an asset or liability.

Net investment hedges happen when a derivative is used to offset the exchange rate risk of the equity of a foreign operation.