Ooh, juicy topic.
This one's all about how to account for derivatives. Puts, calls, options of other flavors, and probably most importantly in practice...futures.
So you're ShmoopWest airlines and you need Jet A fuel to live. That is, without it, your business dies. You have to carry "Middle East Bomb Life Insurance" always, meaning that you always have to hedge your costs of fuel so that in the unlikely event of a water landing, er...a spike in oil prices...you don't suddenly go from paying $40 bucks a barrel for oil to $100.
If you did, then it's likely that virtually all of your competition was at least partly hedged, so their real cost is now more like $70 a barrel. And with the knowledge you didn't hedge, they could drop prices on your routes and drive or fly you out of business fast.
So you own an endless series of futures on oil. And the market is wild. A few quarters go buy and, for whatever reason, you've made a fortune on your hedges.
You're ShmoopWest, not Goldman Sachs. So you don't make a living trading derivatives. How do you account for that quarter's gains? You paid $30 million for hedges expiring the next 2-3 quarters, but rumors of bombs sent oil spiking, and now those hedges are worth $182 million. Do you mark them to market?
It happens to be the end of the year and, if you do, you'll show a gain of $152 million. Misleading? Maybe. Shareholders don't expect you to make a business trading hedges; they want you to fly your damn planes on time. And how do you really account for hedges anyway, particularly when they get all exotic? Like...a call on a call with a swaption embedded? You need a PhD half the time just to understand what these things even mean, much less how to price them.
So maybe you just leave your hedges at book value, i.e. whatever you paid for them, and then as they expire, you do the cash calculations as to whether they made or lost money for you. This is an exceptionally difficult problem in hedge funds...the things that take 20% of profits each quarter as their compensation.
Like...fancy math might show a huge gain one quarter in a blip on a call on a call; the hedge fund would clip a huge gain from that trade that quarter, only to see it all unwind and be worthless 90 days later. Vastly complex area.
Caveat Emptor: if you don't trust the hedge fund managers with your wallet, don't invest. The accounting is just gnarly (technical term).
Related or Semi-related Video
Finance: What are Interest Rate Options?3 Views
Finance Allah Shmoop What are interest rate options All right
people you may need a big loan in three years
It's all about the storms And the big sees you
know with the amount of destruction they'll do to the
oil rigs you manage out there right you big oil
company Global warming has in fact changed weather patterns So
you have no idea if you'll actually need five billion
dollars in debt to buy and or build a new
one But today you mister or missus or Miss CEO
today interest rates are cheap The Fed is almost giving
away money in two and a half percent interest which
means that you can get a loan at Summit for
ish percent interest rate since so much money is involved
here like five billion dollars Well the move of one
percent or one hundred basis points is big and times
were good now and well you really want certainty So
in order to reduce risk you buy an interest rate
option that is You pay one hundred million dollars for
the right three years from now too Then get alone
of call it three billion dollars and note that you
don't have to get the full five billion dollars if
rates go up in the last two billion is expensive
money while fen you figure inflation has hit big time
and you can just well raise prices on oil and
you know or your services to the big oil Cos
right because that's what you do for a living That
hundred million dollars is a call option on future interest
rates that well may or may not be there right
Like it might expire worthless Or it might be worth
a fortune if rates or seven eight nine percent So
what happens if the Fed doesn't budge and rates are
identical in three years Toe what they are today you
lose it All right You lose all hundred million dollars
for that call option You bought Goldman Sachs or Morgan
Stanley or whatever Big Bank took the risk on the
other end of that trade Just made one hundred very
large just for you know being there But you don't
feel bad about it Why Well because interest rates are
still then super cheap At four percent it's kind of
like term life insurance only for the finance world Piccoli
for big oil companies or big capital expense kind of
cos every month that goes by and you lose the
fifty eight bucks you spent on that million dollar policy
you personally bought for your wife and kids If you
get hit by a bus well you feel good to
have wasted that fifty eight dollars because well the alternative
is you know that you don't have a life You
know we don't just mean that Then your social calendar's
empty And your best friends are your Star Wars action 00:02:26.92 --> [endTime] figures no
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