Academic journal article Federal Reserve Bulletin

Overview of Derivatives Disclosures by Major U.S. Banks

Academic journal article Federal Reserve Bulletin

Overview of Derivatives Disclosures by Major U.S. Banks

Article excerpt

Gerald A. Edwards, Jr, Assistant Director, and Gregory E. Eller, of the Board's Division of Banking Supervision and Regulation, prepared this article.

An important source of information about derivatives activities has been the published annual reports and other publicly available financial reports of banks and other companies. Meaningful disclosures about derivatives help users of financial statements to better understand derivatives activities and thus promote market discipline. Banking organizations and the accounting profession have taken a number of steps in recent years to improve the quality of disclosures about derivatives activities. Promoting meaningful disclosures and analyzing this information are important parts of the Federal Reserve's supervisory approach to derivatives activities of banks.(1)

This article discusses the disclosures about derivatives activities in the 1993 and 1994 annual reports of the top ten U.S. banks that deal in derivatives. It also summarizes the accounting standards and recommendations of industry groups and regulators that contributed to the 1994 disclosures. The main thrust of these efforts has been to make derivatives more transparent," in that relevant information is presented in a way that allows the public and regulatory authorities to make informed judgments about a company's derivatives activity. Finally, the article reviews the improvements in qualitative and quantitative disclosures since 1993.

BACKGROUND

In the past year, some highly publicized financial losses were attributed to derivative contracts that were held by several large corporations and municipalities. As a result, public attention has focused on derivatives. Although most financial market professionals see derivatives as efficient tools for managing risk, widespread confusion about them persists among the public. Much of the confusion may stem from the recent increase in the complexity of these instruments.

A standard definition, which will be used here, is that a derivative is a financial contract whose market value depends on the value of one or more underlying "goods." The underlying good can be a commodity, such as a metal or an agricultural product; a financial instrument, such as a stock, bond, or foreign currency; or an index, such as an interest rate or equity index. More simply, a derivative is a contract between two parties in which they agree to fix the price of something today for exchange, or settlement, on a future date. The amount of cash changing hands between the parties is calculated on the settlement date and is based on the difference between the prevailing market price for the good and the price specified in the contract.

The following example illustrates a frequently used type of derivative, a forward contract, in which the buyer agrees to purchase and the seller agrees to deliver a commodity at a specified price on a certain date.

Two companies, a fuel distributor and a manufacturer, decide to enter into a derivative contract. The distributor has an inventory of 1,000 gallons of gasoline, about three months' supply. The manufacturer purchases 1,000 gallons of gasoline about every three months for use in its factory. On the one hand, the distributor is worried that the price of gasoline will fall in the near term from its current, or spot, price of $1 per gallon; on the other hand, the manufacturer is concerned about price increases. They enter into a derivative contract in which the distributor agrees to sell 1,000 gallons of gasoline on a specific date three months hence at $1 per gallon, and the manufacturer agrees to buy it then at that price. Rather than deliver the gasoline on a date that may be close to but not exactly the same as the date on which the manufacturer needs to buy it, they will instead settle in cash. Three months later, the spot price is $0.85 per gallon. In settlement of the contract, the manufacturer pays the distributor $150, that is, $1. …

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