Posted by & filed under Derivatives.

Today I’ll cover the last of the three criteria to the accounting definition of a derivative. Here are all three one more time:

a) There are i) one of more ‘underlyings’ and ii) one or more ‘notionals’ or payment provisions, or both;

b) There is no initial investment or an investment that is smaller than that normally expected of a contract that responds to market changes in a similar manner (i.e., delivers net gains and losses);

c) The contract can be net settled i) under the contract terms (i.e., the party in the net loss position ‘pays’ the party in the net gain position), ii) through a market mechanism (e.g., the contract trades on an exchanged) or iii) by delivery of a derivative or delivery of an asset that is readily convertible to cash (e.g., publicly traded stock).

Net settlement under the terms of the contract is met if neither party is required to deliver an asset that is associated with the underlying and that has a principal amount, stated amount, face value, number of shares, or other denomination that is equal to the notional amount (or the notional amount plus a premium or minus a discount). Net settlement may be made in cash or by delivery of any other asset, whether or not that asset is readily convertible to cash. The party in the loss position simply pays (in cash or whatever) the party in the gain position an amount equal to the net gain/loss of the contract.

Let’s look at an interest rate swap. The swap has two legs, a fixed rate leg and a variable rate leg. One party to the swap will receive a fixed rate of interest and pay a variable rate. The other party will have the exact opposite position…receive variable and pay fixed. When variable rate, which is usually tied to an interest rate index such as LIBOR, is below the fixed rate, the party that pays the fixed rate amount is in a loss position because the fixed interest payment is greater than the variable interest that he will receive. The other party is in a net gain position. In a swap, the parties do not exchange gross interest amounts (i.e., one party pays the fixed payment and the other party pays the variable payment). Instead, the net position is calculated (fixed minus variable or variable minus fixed) and the party in the net loss position pays the other party the amount of the net loss.  That is contractual net settlement.

Another example of net settlement is the cashless exercise of a stock purchase warrant. Cashless exercise is built into many warrants because the Rule 144 holding period carries over to the underlying stock by law. In other words, the holding period doesn’t start new when the holder exercises the warrant under cashless exercise making the stock freely tradable much sooner (or immediately). Anyway, cashless exercise is a common feature and instead of receiving the number of shares that the warrant is exercisable into, the holder receives shares based on a formula:

Fair value of stock * number of shares issuable on exercise

minus exercise price * number of shares issuable on exercise

divided by the fair value of the stock

This places the holder in a net position as if he had exercised the warrant, received the full number of shares, and the sold just enough shares to recover the gross exercise price paid.

Net settlement through a market mechanism is achieved if one of the parties to a contract is required to deliver an asset of the type described in ASC 815-10-15-100 (it’s long so I won’t repeat it here, but do take a look), but there is an established market mechanism that facilitates net settlement outside the contract. Many derivatives are traded on exchanges (interest rate swaps, currency swaps, warrants, options, commodity contracts, for example). Other qualifying market mechanisms include, among others, over-the-counter arrangements, and private transactions where there are multiple market participants willing and able to enter into a transaction at market prices. Evaluation of this criteria should be made at inception of the contract and throughout its life. If a market mechanism for net settlement disappears after the initial assessment, and there is no other means for achieving net settlement (as described here), then the net settlement criteria is not met and the instrument no longer meets the definition of a derivative.

Net settlement through delivery of a derivative contract or asset that is readily convertible to cash is met if the “readily convertible to cash” criteria in the glossary to ASC 815 are met. The characteristics include: (1) interchangeable (fungible) units, and (2) quoted prices that are available in an active market that can rapidly absorb the quantity held by an entity without significantly affecting the price. These characteristics often make thinly traded commodities and stocks unable to meet the criteria, even if the owner might be able to borrow using the assets as collateral. One way to evaluate this criteria is to estimate the amount of cash that would be received in a net settlement arrangement versus the amount of cash that would be received by converting the asset or derivative received to cash. If the difference is significant, say more than 10%, then the asset or derivative is probably not readily convertible to cash under this definition.

When evaluating whether there is sufficient volume to absorb the asset delivered, the ASC requires that you look at the smallest quantity that the holder can receive under the contract, not the entire quantity of the contract. In other words, if an investor buys ten $10,000 convertible notes (totaling $100,000) that he can convert into shares at $10 per share, the number of shares used to evaluate whether there is sufficient volume is 1,000 shares (one $10,000 note divided by $10 per share). That the investor holds ten such notes is not relevant.

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