 Hello, and welcome to the session in which we will discuss derivative instruments. What are derivative instruments? Simply put, they are financial instruments. What are financial instruments? Stocks, bonds, commodities, those are financial instruments. But those financial instruments, they derive, they get their value from the value of other asset. Hold on a second, didn't you say financial instrument is an asset? Yes, but this instrument derive, gets its value from other assets. Let me give you a quick example. For example, let's talk about an equity investment, stock, equity investment, equity investment. This is an asset. Now this is an asset. Related to this asset, we could have a derivative instrument. What is a derivative instrument? Let's assume this is the Google stock. The Google stock, let's assume today is $3,000. Here's what's going to happen. Today, the price of the stock is $3,000. What can we do? We can create another instrument called, let's assume, call it a call option, just for now, a call option. And this is the derivative instrument. And this call option, this asset, this new asset, will derive its value from the price of the stock of Google. How? Let's assume you want to buy Google. You want to buy Google stock, but you don't have enough money today because the stock price is $3,000. And let's assume you want to buy for the sake of illustration, 100 stocks. If you want to buy 100 stocks, we're looking at $300,000. Well, you don't have $300,000 today. What would you do? Well, what you will do is you will buy another financial instrument that will give you the option, this is called the call option, to buy the stock price of Google, maybe at $3,050. Hold on a second. Why would I want to buy it in $3,050 if I can buy it for $3,000? Well, guess what? You're going to have a period of time. You might have, for example, six-month period to buy the stock at $3,050. So this call option is the new financial instrument that's given you the option to buy the stock price at $3,050 to buy 100 shares. Now, you might be saying, okay, but how does this call option derive its value? Here's what's going to happen. Let's assume two weeks later, you purchase this option, you pay a certain amount of money, now you have this option to buy the stock price at $3,050. Let's assume you paid for the option for the sake of illustration, you paid $1,000 to someone to give you the option to buy it. Now, let's assume two weeks later, Google stock jumped to $3,200. Well, guess what? Since the stock price jumped to $3,200, now your option is worth more. Why? Because you have the option to buy it at $3,050 and the stock price itself, the stock itself is $3,200. That gave this new asset more value. So this way, the new asset, the financial instrument that's called the call option, the derivative, increased in value because the stock price of Google went up. So this is basically a simple example. But what assets we can use to create derivative instrument about? We can do stocks. I just told you if you want to buy or sell bonds, gold, foreign currency, commodities, so on and so forth. So the question is, what is the purpose of derivatives? If these, what derivatives are? If this is what derivative is, what is the purpose of them? Well, the main purpose of derivatives is to hedge risk. Or we can use it for speculative purposes. A speculative means for gambling to make money quickly. We are speculating. We're going to be focusing more, we're going to cover both, but we're going to be focusing more on hedge risk. What is hedge risk? Is to protect your risk. And for the purpose to be more technical, we're going to have two types of hedges, fair value hedge and a cash flow hedge, which we'll talk about later. Each one will have it separate recording, but we have to understand the big picture here. What is a hedge risk? Hedge means protect yourself. If we go back to that example for Google stock, what is your, why are you hedging your risk? Because you want to buy Google stock and you fear your risk is Google stock is going to shoot to 3,500. But someone is giving you the option. If you give them some money today, you pay a fee to them, they will, they will secure the Google stock at 3,050. Now, what is the incentive for the other party? We'll talk about that later. Well, maybe the other party bought it at 2,000 and now the stock price is 3,050 and they want to, they want to log their game. Well, that's beside the point. What's the incentive of the other party? We can talk about that later. But the point is you want to hedge your risk. And the other party wants to hedge the risk as well, because whoever's selling you that contract thinks Google stock's going to go down to 2,500. Right? So now they, okay, they will sell you the option and make some profit on that option. Okay? So the point is there's a motive for both parties. Just keep that in mind. Now, what type of risks can we hedge with derivative instrument? It's unlimited. And who uses them? Anyone can use them. For one thing, for example, if we're looking at airline companies, airline companies, they use a lot of fuel. Fuel prices go up and down. For example, they don't like price fluctuation. Companies don't like price fluctuation, because it's going to hit the profit. If the price went up unexpectedly and you need to buy the fuel, then guess what? Your profit goes down because you cannot easily raise your prices. So what happen is you would use those derivative instruments to buy options to buy. I'm going to keep using the word buy, but you can buy or sell these derivatives to buy options to secure the fuel prices at a certain price to help yourself. For example, banks, they lend money out. Well, guess what? They are exposed to interest rate changes. Well, guess what they do? If that's the case, they can buy something called swaps and we'll talk about swaps later. Companies, Johnson & Johnson, PepsiCo, McDonald's, all these companies sell their product overseas. And when they sell their product overseas, they receive foreign currency. This foreign currency could go up in value. This foreign currency could go down in value. So they have a risk where the risk is going down. So what they do? They use derivative instruments and we're going to see what type of derivatives instrument they use to do what? To protect themselves just like I protected myself by buying the Google option. They protect themselves from foreign currency exchanges. Again, investor buying stocks. That's what you do. You buy the option because you want to kind of lock your price because the price may go up too high or it may go down a lot. So you want to hedge your stock position. Coffee growers and coffee shops. For example, coffee growers, they want to secure a certain price for their product. Coffee shops, they want to buy the product. Therefore, they want to secure a certain price. So they will buy derivative instruments. Potato producers and McDonald's. McDonald's need french fries. French fries come from potatoes. So what they do, they go into these derivatives instruments where they will try to secure the price to hedge their risk. So this is the purpose. For example, if you want to buy your tax book, if you can find someone for next semester and tell them, look, I want to buy this tax book, I need it for next semester because there's a shortage of this tax book. Guess what? I will give you $5 now and you will sell me this book at $100. Okay? So basically you paid $5 a day and you'll pay for the book for $105. So the total, your total cost is $105. Now, why would you do that? Why would you go, why would you buy this derivative instrument given $5 to someone and that someone will secure the book for you? Well, because when the semester starts, you may not be able to find the book unless you pay $150 because there's a shortage. Let's assume that's the case. There's no shortage anymore in tax book because we have e-books, but I'm trying to make the point here. Therefore, you will buy this contract to hedge your position, to hedge your risk. So make sure you don't pay more than $105. Now, let's be a little bit more specific. We have three types of derivatives instrument that we can use to hedge the risk. Before we look at the three types of derivatives instruments, 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, whether you are a CPA candidate or an accounting student. I don't replace your CPA review course nor your accounting course. 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Three different types of derivatives are options, future contract, and swaps. And let's talk about each one of them separately. Options. What is an options? Well, we could have two types of options. We can have a call option and we can have a put option. And basically this is just an introductory just to show you how things work. We're going to look at these little more in details in a separate recording. What is a call option? The call option gives you the right. And here I put not the obligation. And you're going to see why I said not obligation. The right to buy something, for example, number of stocks. And we call the quantity, the notional amount at a particular price. And we call the price the underlying amount for a period of time. If we go back to my Google example, remember, I bought the option to buy Google 100 shares of Google at a price of $3,050. Okay, this was my option. This was, this was, this, if I want to do that, I will buy a call option. I will buy a call option for to buy those stocks. This is what a call option. What is a put option? The right to sell something. Well, 100 shares of stocks, 100 shares of Google at a particular price, $3,050. So if you own the stock and your fear is the stock price could go down. Google stock could go down and you have 100 shares of Google stock. You want to hedge your risk. Remember, it's about hedging. You want to protect your risk. Why? Because you think the stock's going to drop to 2,500. What you do is you buy an option, giving you the right to sell the stock at $3,050. Well, why would the other party do that? Because they think the opposite. They think the stock price is going to go up. Well, you think it's going to go up. They think it's going to go down. You have a deal there. So this is the first type of derivatives that you can use. And don't worry, we're going to have a separate recording for options where we do actual accounting, but this is the big, big. Let's look at type two and type three of derivatives instrument, future and forward contract. What are future contracts? Starting with future contract. Future contract is an agreement between the seller and the buyer that will require the seller to deliver a particular commodity, oil, gold, cattle, whatever that is, coffee beans. That's what it is. So why would somebody go into this contract? Well, let's assume, again, you're an airline company. You want to secure fuel, oil, fuel. What you do is you buy a future contract because the airline company, they actually need the actual fuel, the physical fuel. They don't care about making a profit. They're not looking, they are not looking to make a quick profit like a speculator or a trader. They're looking for the actual thing because that's how they run their operation. They need fuel, they need oil. Same thing with Starbucks. They need coffee beans. So what they do, they go into this agreement, they buy that this future contract, usually from a producer that will sell them the product. And future contract are traded on an organized exchange. They're regulated, notably the Chicago Mercantile Exchange. This is an organized exchange. It's like the New York Stock Exchange. If the contract involves financial instrument, what does that mean? It means it doesn't involve commodity. Then we call this contract financial future contract. Now those, they can be settled in cash, but the other one, when they buy them, they want the product itself. That's the purpose. Now we have a future contract and notice I have them under the same category. Well, rather than a future, we can buy a forward contract. It's similar to a future contract, but the agreement is customized between two parties. What does that mean customized? It means they can put any conditions in there. It's not, it's between two parties. It's a contract. It's either you can deliver the product or it's done in cash settlement. So you don't have to deliver the product. You can do it in cash settlement. Those forward contract are not traded on an exchange. They're traded over the counter. And who would do them counter? Who would do them? Who would get involved in these forward contract? People that know what they're doing because usually those are you want, maybe you want to trade. But again, why are they called derivatives instrument? Because if the contract is based on the price of gold, well, if the price of gold goes up and down, it will affect this contract. That's why they're called derivatives. They derive their price from something else. And the third type of derivatives instrument is swaps. And what is a swap? It's an exchange of cash flow stream between two parties. And we're going to talk about swaps later on. And this is usually used to hedge interest rate risk. Again, I'm not going to get into swaps today because we're going to have a whole session about swaps and how they work. Actually, I already have the session, you can view it on my channel. But this is the third type of derivatives. At the end of this recording, that's all what I'm going to do today. Just introduce to you the idea, the basic idea of derivatives, why that's important. Because when we're going to start to do journal entries and start to do basic accounting next, this is what we're going to be doing next, accounting for derivatives. It's very important to understand the big idea. Why am I doing this? What's the purpose of this? Why do I have a game? Why do I have a loss? You will understand why. What should you do now? Go to farhatlectures.com and start to work MCQs to learn more, to look at additional resources, to study the material, invest in yourself. Don't shortchange yourself. It's very important to understand the topic so you can pass your CPA exam, move on with your career. Good luck, study hard, and of course, stay safe.