 Hello and welcome to the session in which we would look at accounting for derivative instruments specifically when it comes to speculation. In the prior session we looked at what are derivative instruments. If you're not sure what derivative instruments are, please look at the prior recording, but we need to understand there are two purpose for derivative instruments. One is hedging, the second one is speculation. In this session we're going to be looking at speculation and obviously we will work on hedging later on. What is speculation? Who would use such instruments for speculation purposes? What's a speculator? Speculator think of them as traders, gamblers, someone who might buy a financial instrument for few hours, few days then sell them to another party. Simply put the purpose of their investment in quote the purpose of their purchase is to make a profit. Obviously everyone wants to make a profit whether you are buying the financial instrument for hedging or for speculation but the purpose here is that you don't have a position to hedge. You don't have a position to protect. You are not protecting a position. You're not buying the derivative instrument because you own a stock and you want to protect the value of that stock or you want to protect the value of your foreign currency transaction or you want to buy oil in the future market for your business purpose. The purpose why you would buy those financial instruments is strictly to make a profit from buying and selling not to protect the position and the reason I'm emphasizing this point is because when we talk about hedging, when we discuss hedging, hedging is totally different. You are buying a financial instrument however the purpose of your purchase is to hedge a position to protect a position and there's another group of investors or people or companies that that get involved in what's something called arbitrage or arbitrage. What they do is they find discrepancy in prices on various markets and they buy and sell the same price simultaneously to take advantage of the price spread. I'll give you a quick example and the reason I'm mentioning arbitrage and speculators because in your textbook they might mention it and I don't want you to be confused. For example, let's assume you own a stock and right now on the New York Stock Exchange so in USA the stock on the New York Stock Exchange is trading at $149.51 so you can sell it right now at $149.51 so what you would do is and you know in Tokyo you have an account in Japan in Tokyo and the same security you can buy at $149.50 what would you do? You would short you would sell yours immediately at $149.51 and buy immediately the one at Tokyo for $149.50 Simply put you made the penny if you have thousands or millions of shares multiply that penny by a lot but the point is there's a spread there is a price differences between the two markets that should not happen especially with technology today or you would think so right well in the 80s this used to happen more often so it's it's supposed to be less popular or much more popular. If you are interested more in this topic what I suggest you do is pick up a book for Michael Lewis called Flash Boys and he talks about how price this people taking advantage not people companies taking advantage and people as well investors companies are people taking advantage of dose price discrepancy through algorithm and computer speed what we're talking about here is the difference in 100 of a milli seconds but again it's beyond the scope of this recording but it's very interested. Now how to account for derivative instrument for speculation purposes here's what's going to happen we're going to report them at fair value well what does that mean if we have a gain it's going to be considered an asset if we're going to have a loss it's going to be considered a liability and we're going to recognize the gain or the loss in income or net income hedges it's going to depend it's going to mostly net income but it's going to depend on the hedge we'll talk about hedging later on so simply put there are two types of two types of derivative derivative instrument one for hedging and one for speculation for speculation it goes into net income we'll talk about hedging later on let's take a look at an example to illustrate the concept let's assume a ramp company purchases 1000 call option on january 2nd 20x4 to buy apple shares at $190 apple shares were trading at 175 on that date the option expires on april 30th 20x4 adam paid $500 for the skull option let's translate everything what happened is this right now apple stock is trading at $175 what what adam did adam said i'm going to buy the option i want to buy 1000 shares of apple shares but i don't i don't want i don't want to buy them today because i don't have the money for example to buy 100 1000 shares i will buy the option and this option will give me will be option to buy them at $190 so hold on a second why would you buy the option to buy them at 190 if you can buy them for 175 today for one thing i don't have the money two i don't have to buy it today i have till april 30th so between now and april 30th i have time okay this is what i'm buying i am buying time this is what adam is buying now buying time in the hope that apple stock will be above 190 by april 30th if not adam would lose all the $500 so let's start with the journal entry adam will debit an asset called the call option of $500 and they will credit cash $500 what would this option give adam the buy to buy the right to buy apple stock at 190 between now and april well what did adam really purchase for that $500 well as i told you adam purchased time so when you pay for an option the option price gives you two value something we called the intrinsic value and something called the time value now we need to define what is intrinsic value and what is time value before we define intrinsic value and time value i would like to remind you whether you are an accounting student or a cpa candidate to take a look at my website farhatlectures.com i don't replace your cpa review course nor obviously i replace your accounting course my motto is saving cpa candidate an accounting student one at a time how i provide the new resources for your college courses for your cpa examination this is a partial list of all my accounting courses that have lectures multiple choice through faults by cpa resources are aligned with your becker roger wiley and gleam so you can easily go back and forth between my material and your cpa review course and on my website i give you access to 1500 previously released a icpa exam questions in their original format plus detailed explanation you really want to take a look at those before setting for the exam if you have not connected with me on linkedin please do so take a look at my linkedin recommendation like this recording it helps me a lot share it with other connect with me on instagram i'm trying to grow my instagram following facebook twitter and reddit so what is intrinsic value well intrinsic value is the difference between the market price and the preset strike price at any point in time well let's take a look at what we have here the market price of apple is 175 the preset strike price is 190 now you tell me what is the intrinsic value of this option well what does that mean it means what is the difference if i exercise this option today what profit do i make and the reason is i don't make a profit i'll be crazy to do that i'll lose money because i can buy the stock at once 175 why would i pay an additional 15 dollars for it therefore at this point there is no profit we can say that the intrinsic value for this call option is zero there's no intrinsic value okay that's fine so why did i pay 500 as i told you earlier i paid for time time value is the value of the option other than the intrinsic value what is that other value time you are buying time okay so the expectation you're buying the possibility that the option goes above the strike price during the contract period that's what you're buying you're betting on the time and through time the price goes above 190 you make a profit every time the stock is above 190 well so the 500 dollar is strictly paid for time so bear in mind very important make a note of this 500 dollar this is the value of time now the longer you want the contract generally speaking in the real world the longer you want that contract to be so if you want to say i want this option to extend till june end of june well you have to pay more because the more time the more time you have the higher is the price of the option and and vice versa if you want to buy an option till the end of january it's going to be cheaper because you're not buying a lot of time so if you want to buy time you have to pay more generally speaking now let's take a look at what's going to happen post january 1st remember we purchased the contract for 500 dollar and the cold and the strike price is 190 we can buy it at 190 remember now we have an asset called call option we have 500 there because it's an asset for now march 31st we prepare our financial statements and here's what happened on march 31st the market price of apple is 200 and we're going to talk about the time value of the option is 150 okay so what does that mean well that's good that's really good why because i can buy this price for 190 and the price on march 31st is 200 so do i have intrinsic value now i do how much is my intrinsic value well the price the market is 200 my preset is 190 i have $10 of intrinsic value so on march 31st the intrinsic value of the call option is $10 per option remember this is $10 per per one option how many options do i have i have 10 000 so it's $10 times 1000 options i have a gain on the option contract of $10 000 i'm ready to book my gain i'm gonna debit i'm gonna increase an asset i'm gonna increase my call option 10 000 and credit an unrealized holding gain loss that's going to go to income so my call option now notice what happened is i added to my call option 10 000 that's a pretty good deal so think about it i only paid $500 now technically i have a gain of 10 000 now this is the good news the the not so good news is as time goes by my the value of my option the time value goes down now on march 30th i still have one month to go in my time the time value remember the time value was 500 now the time value is only worth 150 now how do i know it's worth 150 usually you can estimate or get an appraisal they will tell you for example the time value of this option is worth such and such so the time value of the option is 150 how did how did you know again you appraise it you ask an expert what's going to happen is remember the time value started at 500 now it's worth 150 i have to reduce my call option by 350 i have to reduce my because i lost time as time goes by by april 30th by the end of april the value of this contract the time value equal to zero because i i don't have any time but now it's still worth something it's only worth 150 therefore i reduce my call option by 150 and i record a loss of 350 so this is what happened so time value goes down as time goes down time value goes down now i can i can report my call option value on the balance sheet as 10150 so notice i saw i invested 500 dollars see the power of options now it's worth 10150 and this that's what goes on the balance sheet now obviously without mentioning this the 10 000 profit and the 350 loss they will go those two will go on the income statement so the net of them i don't know 9 650 which what will go on the income statement let's keep going in time on april 15th right before two weeks before the option expires the market price of apple dropped to 195 and the time value of the option becomes 50 again as time goes by the time value of the option decreases now adam panics and guess what adam did said you know what i'm going to exercise my option i'm going to go ahead and buy the stock at 190 and sell it at 195 because it seems this the stock price is dropping i should have you know maybe adam should have exercised the option on march 31st but you don't know the future so now we're going to do that so decided to exercise the option so before we exercise the option we bring the option up the date up the date means mark to market what happened is this the option now what's my intrinsic value it used to be 10 right on the prior slide was 10 when the price was when the price was 200 it was equal to 10 now the price is 195 the intrinsic value equal to 5 so i have to write down my call option by 5000 okay write it down by 5000 and book a loss of 5000 notice options are very risky hopefully you see this so what happened is i'm going to reduce my call option by 5000 okay to bring my option up to date because i'm going to go ahead and exercise today now i also have to write down my time value of the option it was it was 150 now it went down to 50 well i lost 100 dollars again how do you know the time value it will be given to you in the real world you can ask an expert an appraisal maybe there's a market for that therefore you would write down your call option by additional 100 and take a loss take a loss of 100 dollars so notice now you book losses on the income statement for 5000 100 after all said and done your call option is worth now 5000 and 50 dollars now you are ready to exercise well guess what you'll get cash you're going to sell it you're going to sell the call option and you're going to get cash of 5000 dollar you're going to debit cash 5000 dollar the call you have you're going to have to remove the call option you're going to remove the call option notice you're going to have to remove it to bring the call option down to zero and remember there are still 50 dollars of time value now you're going to lose that time value as well now you would record this time value directly into the income statement as a loss and this is how we settle the option simply put what does that mean all said and done we made we made they made they made a profit they Adam made a good profit on this call option let's see the overall net effect on the income statement by by buying this option first we paid 500 dollars for this option this is basically negative we paid 500 dollars well we had an increase in the intrinsic value of 10 000 then a reduction in the time value of money of 350 by march 30th our income was 9650 april 15th when we decided to exercise the value went down so we had a reduction in the intrinsic value of 5000 reduction in the time value of 100 then on april 15th we lost the remaining 50 dollars of time value all in all our net income is 4500 why we had $5 an intrinsic value times 1000 shares that's $5000 an intrinsic value profit plus we had to pay a fee at the beginning of 500 remember we had to pay a fee of 500 to buy this option so 5000 minus 500 will give you 4500 not a bad deal so you took 500 dollars turn it into 4500 i sound like i'm trying to get you into options don't do options options are very risky but this is for accounting purposes what should you do now go to my website farhat lectures dot com and start to work multiple choice questions about the topic if you're not a subscriber subscribe invest in yourself invest in your career get done with your cpa get done with your accounting education so you could move on with your life and start to buy options options are great you want options and life all sorts of options the best option is time and that's the that's every day we are given the option of time that's the good thing but time goes by and you cannot really buy time don't waste any time study for your exam