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 is a Derivative?23 Views
finance a la shmoop what is a derivative? well it's derived it's a something taken
from something else like a derivative of hot weather is thirst a derivative of [Girl takes sip of glass of water on a beach]
hunger is well you know crankiness that's diva thing you get there...
derivative of a 1/32 quarterback rating in the NFL is like serious wealth yeah
yeah discount double shmoop yeah look for it be on there with aaron
and a derivative of a stock or bond or other security is a something which
derives its value based on the performance of that underlying security
there are basically two flavors of derivative put options ie the right to [Ice cream flavors appear]
sell a security at a given price over a given time period and a call option, ie
right to buy a security at a given price over a given time period
well the price of that option is derived from the price of the security and a few
other factors like strike prices and duration and all that stuff
colonel electric the downgraded new version of General Electric is trading [Colonel Electric appears in a suit]
for 25 bucks a share a derivative of its share price is sold in the form of a
call option with a $30 strike price expiring about 90 days from now on the
third Friday of the end of that month well investors pay a price albeit
probably a small one for the right to then pay 30 bucks a share for colonel [Call option appears for colonel electric]
electric at any time in the next 90 ish days until that option expires making the bet
that the stock will go well above 30 bucks a share in that time period that
call option is thus a derivative of the colonel electric primary stock price got
it if you really want to get personal well here's the ultimate form of
derivative [Baby laying down]
Up Next
How does a hedge fund work? Hedge funds, which deploy an array of strategies that include high risk leverage and derivatives, are private investmen...
What are Interest Rate Options? Interest rate options are call and put option derivatives created to manage fixed income portfolio risk and specula...