Marketing Management
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ACCT405_ch011.pptxChapter 1
Financial Instruments and Institutions
Financial Instruments and Institutions
Fair Value Accounting
According to the text, financial instruments defined by the FASB
“includes financial assets and liabilities but not the firm’s own equity.”
“The firm’s equity is a financial instrument, just not one for which direct fair valuation generally is contemplated.”
“Financial assets are contractual claims to receive cash or another financial instrument on favorable terms or ownership interests in another firm.”
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Financial Instruments and Institutions
Fair Value Accounting
According to the text, fair value is defined as:
“the price that would be received to sell a financial asset or to transfer a financial liability in an orderly transaction between market participants at the measurement date, and so it reflects current expectations of the cash flows and priced risks of the financial instrument.”
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Financial Instruments and Institutions
Fair Value Accounting
Full fair value accounting involves three features:
Balance sheet: Involves recognition of financial instruments at fair value.
Income statement: Involves the recognition of unrealized gains and losses on financial instruments in net income in the period they occur.
Income statement: Involves calculating interest revenue or expense as the fair value of the financial instrument times the applicable current market interest rate during that period.
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Financial Instruments and Institutions
Fair Value Accounting
The alternative to fair value accounting is amortized cost accounting.
Amortized cost accounting uses:
“Expectations of cash flows and priced risks determined at initiation to account for financial instruments throughout their life.”
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Financial Instruments and Institutions
Fair Value Accounting
Amortized cost accounting has three features that are not desired.
Uses old information and provides untimely measures of the value of financial instruments on the balance sheet.
Provides measures of the values of these instruments that reflect expectations of cash flows and priced risks at different times.
Provides firms with the ability to manipulate net income through realizing gains or losses on the sale of financial assets or repurchase of financial liabilities.
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Financial Instruments and Institutions
Estimation Sensitivity and Risk Disclosures
According to the text:
“Subjectivity and noise in estimating fair values, even when leveraged through the retention of risky residual claims, can be mitigated through clear disclosure of estimation assumptions and the sensitivity of fair values to those assumptions.”
“Fair values are point estimates of the current value of financial instruments.”
“Limitations arising from fair valuation of less than all aspects and liabilities can be mitigated through separate presentation of unrealized gains and losses on the income statement and through management discussion of the existence of economic hedges of non-fair-valued exposures.”
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Financial Instruments and Institutions
Gross and Net Evaluation
Financial instruments exhibit the following risks:
Market – are offset across the instruments in a portfolio
Interest rates
Exchange rate
Commodity price
Nonmarket – hard to offset across instruments
Credit
Performance
Insurance
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Financial Instruments and Institutions
Gross and Net Evaluation
“Structured finance transactions that include multiple legs raise the gross and net evaluation issue in a similar fashion as portfolios of financial instruments.”
“The market risks of the various legs of the transactions are more likely to offset than are their nonmarket risks.”
“In contrast, individual derivative financial instruments raise the gross and net evaluation issue in mirror-image fashion to portfolios of financial instruments.”
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Financial Instruments and Institutions
Financial Transactions Are Financial
Financial transactions should be classified and measured in financial reports.
Some financial transactions are operating under current accounting standards.
These transactions include:
Operating leases
Traditional insurance
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Financial Instruments and Institutions
Funds Aggregation
Financial institutions raise funds from:
Depositors
Investors
Customers that reinvest larger amounts of money
Funds may be liquid (deposit) or not so liquid (annuities).
“Funds aggregators exist to exploit some form of economy of scale in investing.”
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Financial Instruments and Institutions
Trading and Investment
“Financial institutions often trade or invest in financial assets on their own accounts.”
“A financial institution usually holds a trading portfolio because it believes it has some advantage over its trading partners in valuing financial instruments that will yield trading gains.”
“It also may hold a trading portfolio to facilitate or as result of its other activities.”
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Financial Instruments and Institutions
Yield Curve Speculation
Fixed-rate financial instruments are sensitive to changes in interest rates.
“The value of a fixed-rate financial instrument varies inversely with interest rates, with the absolute magnitude of the value change rising with the financial instrument’s duration, a measure of the weighted-average time to the cash flows or next repricing of the instrument.”
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Financial Instruments and Institutions
Risk Management
Often, risk managers adjust risk exposures for their clients downward.
Adjustment happens by absorbing the risks themselves.
Diversifying across clients and time.
Transferring the risk to a third party.
Risk managers include:
Insurers
Commercial banks and securities firms
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Financial Instruments and Institutions
Risk Management
Risk managers attempt to generate income by:
Charging a premium for absorbing risk.
Risk premium should fall within the risk manager’s ability to diversify the risk.
Generate income by implicitly or explicitly charging fees.
“A portion of a property-casualty insurance premium is an implicit fee for setting up the policy and for expected future claim adjustment services.”
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Financial Instruments and Institutions
Other sources of fee income include:
Syndication, securitization, and reinsurance
Reverse the investment activities of financial institutions
Market making and brokerage
“Securities firms and large banks may make markets in or broker the trading of financial instruments.”
Deal making
“Securities firms and large banks may execute or advise on various financial deals and receive commissions.”
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Financial Instruments and Institutions
Asset management and investment advice
“Many financial institutions manage or provide advice regarding clients’ investment for fees.”
Transaction processing
“Performance of any financial institution with a high transactions volume depends on its ability to process transactions efficiently in its “back office”.”
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Financial Instruments and Institutions
Valuation of Financial Institutions in Practice
Value of financial institutions comes from two sources:
Portfolio of financial instruments that are or will be valued on the balance sheet at fair value.
Set of future streams of noninterest income and expense with various degrees of risks and persistence.
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