No one should ever drive 70 miles per hour in a 40 MPH zone.
This analogy can be applied to the derivative questions on the FAR test. I’ve seen many CPA candidates plow through a lot of rules and regulations about reporting derivative transactions, without understanding how these financial tools work. The most important goal when studying derivatives is to understand how they work and why they are used. If you understand those concepts, the more detailed rules about posting gains and losses will make more sense. Let’s slow down and get an understanding of two frequently tested areas on the FAR test: stock options and currency hedging.
What’s a Derivative?
A derivative is defined as a security with a price that is dependent or the value of another asset. The increase or decrease in the value of the other asset affects the price of the derivative. Say, for example, that you own football tickets for your local NFL team. The value of your tickets changes, based on the success of your team, which means that winning teams have more demand for their tickets than a losing team. In this example, your football tickets are the derivative, and the football team is the asset.
A stock option is a contract that allows the option owner to buy or sell a specific number of shares of stock. The contract specifies a price for the transaction, and the number of shares that can be bought or sold. Purchasing a stock option means that the option owner can control the buy or sell price of a stock, without having to purchase or sell all of the shares.
Assume, for example, that you own 100 shares of IBM common stock at a purchase price of $50 per share. You’d like to purchase an option that allows you to sell your shares at a price of $55, so you buy a put option. Buying one $55 IBM put gives you the right to sell 100 shares of stock at $55, and you have that right until the option contract expires worthless. If you exercised your option and sold your shares at $55, you gain per share would be ($55 – $50 – cost of the option per share). Buying one $52 IBM call option, on the other hand, gives the option owner the right to purchase 100 shares at a price of $52 per share. If the price of IBM stock moves above $52, the call option is more valuable.
U.S. firms that do business internationally must fund their foreign operations by converting dollars into another currency. At the end of a month or year, the U.S. firm may take the profits and convert them back into dollars, or send over more working capital. Moving from one currency to another may generate gains and losses, and many firms manage this risk by hedging their currency transactions.
Assume, for example, that IBM needs to send capital to its French division, and that one U.S. dollar buys two euros. IBM sends $10 million, and those dollars are converted into 20 million euros. At the end of the month, IBM sends an addition $10 million to France, but the exchange rate is now one U.S. dollar buys one euro. Based on the new currency rate, $10 million only buys 10 million euros.
If IBM needs to send dollars to France, the firm can purchase a currency option, which is also called a forward contract. IBM pays a fee for the right to use a fixed currency rate for a specific period of time. This contract reduces some of the currency risk, or the risk that the dollar will become less valuable in comparison with the euro. The cost of the currency option is an additional expense to IBM.
Before taking the FAR test, make sure that you’re clear about these two derivative concepts. If you understand why these derivatives are used, you can answer FAR test questions with more confidence.