SFAS 133 Glossary
Accounting for Derivative Instruments and Hedging Activities
Last Updated on July 24, 1998
Bob Jensen at Trinity University

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Beginning of SFAS 133 Glossary
Accounting for Derivative Instruments and Hedging Activities

a term used in alternate ways. In one context, accounting exposure depicts foreign exchange exposure that cannot be captured by the accounting model. In some textbooks accounting exposure is synonymous with translation exposure. See translation exposure.

Anticipated Transaction = see forecasted transaction.

At-the-Money = see option and intrinsic value.

Backwardation = see contango swap.

Basis =

difference between the forward (strike) price and the spot price of a derivative such as a futures contract or the forward component  in an options contract. Alternately basis can be viewed as the benefits minus the costs of  holding the hedged spot underlying until the forward or futures settlement date.  Also see intrinsic value.

Basis Point =

interest rate amount equal to .0001 or 0.01%.

Basis Swap = see interest rate swap.

Benchmark =

a foreign currency translation rate used as an internal budget rate or as a reference rate for measuring alternative hedging decisions.

Black-Scholes Model = see option.

Blockage Factor =

the impact upon financial instrument valuation of a large enough "block" of voting rights to influence strategy and control of an organization (e.g., a 51% block of voting shares versus 1% non-block). = If voting power is widely dispersed, less than 51% may constitute a blockage factor if the "block" is significant enough to exercise control. The FASB does not allow blockage factors to influence the estimation of fair value. Blockage is discussed in SFAS 133, Pages 153-154, Paragraphs 312-315. See fair value.

Call = see option.

CAP =

a risk bound.  For example, a cap writer, in return for a premium, agrees to limit, or cap, the cap holder's risk associated with an increase in interest rates. If rates go above a specified interest-rate level (the strike price or the cap rate), the cap holder is entitled to receive cash payments equal to the excess of the market rate over the strike price multiplied by the notional principal amount. Issuers of floating-rate liabilities often purchase caps to protect against rising interest rates, while retaining the ability to benefit from a decline in rates. See SFAS 133 Paragraph 182.

Capital Asset Pricing Model (CAPM) =

a model for valuing a corporation in which estimated future cash flows are discounted at a rate equal to the firm's weighted average cost of capital multiplied by the beta, which is a measure of the volatility of a firm's stock price.  The CAPM is a single-index model and, as such, has enormous structural deficiencies.  Alternate approaches and problems in all approaches are discussed in http://www.trinity.edu/~rjensen/149wp/149wp.htm    Also see option pricing theory.

Cash Flow Hedge =

a derivative with a periodic settlement based upon cash flows such as interest rate changes on variable rate debt. Major portions of SFAS 133 dealing with cash flow hedges include Paragraphs 28-35, 127-130, 131-139, 140-143, 144-152, 153-158, 159-161, 162-164, 371-383, 422-425, 458-473, and 492-494.   See hedge and hedge accounting.

CBOE =

Chicago Board Options Exchange.  See http://www.cboe.com/    Also see CBOT and CME.

CBOT =

Chicago Board of Trade.  See http://www.cbot.com/   Also see CBOE and CME.

Circus =

a combination that entails both an interest rate swap and a foreign currency swap.  One of my students wrote the following case just prior to the issuance of SFAS 133:

Brian T. Simmons For his case and case solution entitled ACCOUNTING FOR CIRCUS SWAPS: AN INSTRUCTIONAL CASE click on http://www.resnet.trinity.edu/users/bsimmons/circus/framecase.htm
This case examines a basic circus swap which involves not only the exchange of floating interest rate for fixed, but also one currency for another. Separation of the effects from both interest rate and foreign currency fluctuations is no simple matter. In fact, no formal accounting pronouncements specifically address this issue.

The introduction first reviews the history and reasoning of pronouncements leading up to Exposure Draft 162-B. For years, institutions have relied on settlement accounting to record their derivative instruments. With growing concern over the risk of these instruments, however, the SEC and FASB have attempted to increase the detail of disclosure regarding the value and risk of their derivative portfolio. The case provides an example of a hybrid instrument in the form of a circus swap. The case questions review the accounting for these types of instruments under the current settlement accounting guidelines as well as the new fair-value method. Additionally, a simplistic measure of Risk Per Contract (RPC) is developed. By using information that is easy for management to obtain, the likelihood of the benefits of RPC outweighing the costs is greatly enhanced.

Clearly or Closely Related Criteria = see hedge.

CME =

Chicago Mercantile Exchange.  See http://www.cme.com   Also see CBOE and CBOT.

Collar=

a hedge that confines risk to a particular range. For example, one form of collar entails buying a call option and selling a put option in such a manner that extreme price variations are hedged from both sides. In Paragraph 181 on Page 95 of SFAS 133, a timing collar is discussed.  Also see floater.

Collateralized Mortgage Obligation CMO =

a priority claim against collateral used to back mortgage debt. This is considered a derivative financial instrument, because the value is derived from another asset whose value, in turn, varies with global and economic circumstances.

Commitment Exposure =

economic exposure arising from the effects of foreign currency fluctuations on the cost curves of competitors. See firm commitment and hedge.

Competitive Exposure =

economic exposure arising from the effects of foreign currency fluctuations on the cost curves of competitors.

Compound Derivatives =

derivatives that encompass more than one contractual provision such that different risk exposures are hedged in the compound derivative contract. SFAS 133, Pages 167-168, Paragraphs 360-361 discusses how the FASB clung to its position on pro rata decomposition in SFAS 133 vis-à-vis the earlier Exposure Draft 162-B that also did not allow pro rata decomposition. Further discussion is given in Paragraphs 523-524.  See derivative and embedded derivatives.

Closely related are synthetic instruments arising when multiple financial instruments are synthetically combined into a single instrument, possibly to meet hedge criteria under SFAS 133. SFAS 133 does not allow synthetic instrument accounting. See Paragraphs 349-350 on Page 164 of SFAS 133.  Example 11 in Paragraphs 176-177 illustrate clearly-and-closely-related criteria in embedded hybrid derivative instruments.  These criteria are discussed under hedge.

Comprehensive Income or Other Comprehensive Income (OCI) =

the change in equity of a business entity during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners (FASB Concepts Statement No. 6, Elements of Financial Statements paragraph 70). The FASB’s ED 162-A proposed a standard on comprehensive income accounting that eventually became a standard in SFAS 130. SFAS 133 sought to book financial instrument derivatives without changing net earnings levels prior to issuance of SFAS 133. Accordingly, booking of derivative hedgings at fair market value, especially cash flow hedges, entails deferral of earnings in Other Comprehensive Income until cash settlements transpire. Comprehensive income is discussed at various points in SFAS 133, notably Paragraphs 46-47, 18c, 127-130, 131-139, 140-143, 144-152, 162-164, 165-172, 173-177, and 338-344.

Contango Swap = the following according to one of my students:

A contango swap is a commodity curve swap, which enables the user to lock in a positive spread between the forward price and the spot price. A producer of a commodity, for example, might pay an amount equal to the 6-month futures contract and receive a floating payment equal to the daily price plus a spread. This enables the commodity producer to lock-in the positive spread and hedge against anticipated backwardation.    Her project on such a swap is as follows:

Debra W. Hutcheson For her case and case solution on Accounting for Commodity and Contango Swaps, click on http://www.resnet.trinity.edu/users/dhutches/project.htm
This case examines the interplay of a cotton consumer and a cotton producer, both participating in a commodity swap, one of the many commodity-based financial instruments available to users. Each party wants to protect itself from commodity price risk and the cotton swap allows each participating party to "lock-in" a price for 6 million pounds of cotton. One party might lose in the cotton swap and, therefore, must enter into some other derivative alternatives. Additionally, this case examines the requirements for accounting for these contracts under the FASB’s latest exposure draft on accounting for derivatives and the "forward-looking" disclosure required by the SEC.

The term "contango" is also used in futures trading.  It refers to situations in which the spot price is higher than the futures price and converges toward  zero from above the futures price.  In contrast, backwardation arises when the spot price is lower than the futures price, thereby yielding an upward convergence as maturity draws near.

Covered Call  =

simultaneous writing of a call option and the underlying asset such as the underlying stock. A covered call reduces upside risk. See Paragraph 399 on Page 181 of SFAS 133.  Also see option and written option.

Credit Risk Swap =

a form of insurance against default by means of a swap. See Paragraphs 190 and 411d of SFAS 133. See Risks. One of my students wrote the following case just prior to the issuance of SFAS 133:

John D. Payne For his case and case solution entitiled A Case Study of Accounting for an Interest Rate Swap and a Credit Derivative click on http://www.resnet.trinity.edu/users/jpayne/coverpag.htm
The objective of this case is to provide students with an in-depth examination of a vanilla swap and to introduce students to the accounting for a unique hedging device--a credit derivative. The case is designed to induce students to become familiar with FASB Exposure Draft 162-B and to prepare students to account for a given derivative transaction from the perspective of all parties involved. In 1991, Vandalay Industries borrowed $500,000 from Putty Chemical Bank and simultaneously engaged in an interest rate swap with a counterparty. The goal of the swap was to hedge away the risk that variable rates would increase by agreeing to a fixed-payable, variable-receivable swap, thus hopefully obtaining a lower borrowing cost than if variable rates were used through the life of the loan. In 1992, Putty Chemical Bank entered into a credit derivative with Mr. Pitt Co. in order to eliminate the credit risk that Vandalay would default on repayment of its loan principal to Putty.

A good site on credit risk is at http://www.numa.com/ref/volatili.htm   

Example 24 in Paragraph 190 of SFAS 133 discusses a credit-sensitive bond.

Cross Rate =

the exchange rate between two currencies other than the dollar, calculated using the dollar exchange rates of those currencies.

Crude Oil Knock-in Note = 

a bond that has upside potential on the principal payback contingent upon prices in the crude oil market.  Such a note is illustrated in Example 21 in Paragraph 187 of SFAS 133.

CTA = a term with alternate meanings.

Commodity Trading Advisor - One who provides advice on investing in currencies as a separate asset class. Some also act in a separate function as overlay managers, advising on hedging the currency risk in international asset portfolios.

Cumulative Translation Adjustment - An entry in a translated balance sheet in which gains and losses from transactions have been accumulated over a period of years.

Currency Swap =

a transaction in which two counterparties exchange specific amounts of two different currencies at the outset and repay over time at a predetermined rate that reflects interest payments and possibly amortization of the principal as well. The payment flows are based on fixed interest rates in each currency.    An example of a currency swap in SFAS 133 appears in Example 5 Paragraphs 131-139 on Pages 72-76.

Current Rate =

The exchange rate in effect at the relevant-financial-statement date.

Dedesignation =

a change in status of a designated hedge such that all or a portion of the hedged amounts must be taken into current earnings rather being deferred.  For example, see Example 9 in SFAF 133, Paragraphs 165-172 on Pages 87-90.  Example 9 illustrates a forward contract cash flow hedge of a forecasted series of transactions in a foreign currency.  When the forecasted transactions become accounts receivable, a portion of the value changes in the futures contract must be taken into current earnings rather than other comprehensive income.  Another illustration of dedesignation is in Example 7 of SFAS 133, pp. 79-80, Paragraphs 144-152.  See hedge.

Delivered Floater = see floater.

Derivative =

A financial instrument whose value is derived from changes in the value of some underlying asset such as a commodity, a share of stock, a debt instrument, or a unit of currency.  A nice review appears in Myron Scholes' Nobel lecture that is reprinted as "Derivatives in a Dynamic Environment," American Economic Review, June 1998, 350-370.  For further elaboration, see derivative financial instrument.    Especially note the terrms hedge and disclosure.

Derivative Financial Instrument =

a financial instrument that by its terms, at inception or upon the occurrence of a specified event, provides the holder (or writer) with the right (or obligation) to participate in some or all of the price changes of an underlying (that is, one or more referenced financial instruments, commodities, or other assets, or other specific items to which a rate, an index of prices, or another market indicator is applied) and does not require that the holder or writer own or deliver the underlying. A contract that requires ownership or delivery of the underlying is a derivative financial instrument if (a) the underlying is another derivative, (b) a mechanism exists in the market (such as an organized exchange) to enter into a closing contract with only a net cash settlement, or (c) the contract is customarily settled with only a net cash payment based on changes in the price of the underlying.  What is most noteworthy about derivative financial instruments is that in the past two decades, the global use of derivatives has exploded exponentially to where the trading in notional amounts is in trillions of dollars.  A nice review appears in Myron Scholes' Nobel lecture that is reprinted as "Derivatives in a Dynamic Environment," American Economic Review, June 1998, 350-370.    Types of derivative financial instruments include futures contracts, forward contracts, interest rate swaps, foreign currency derivatives, warrants, forward rate agreements, , and complex combinations of such contracts.    See hedge and financial instrument.

Disclosure =

the disclosures of key information in footnotes, special schedules, or other parts of financial reports. SFAS 133 deals with disclosure at various points, especially in Paragraphs 502-513 on Pages 216-221. The SEC has more controversial disclosure requirements for derivatives, especially requirements for quantification of risk.

Some SEC rules, which amend Regulation S-X and Regulation S-K, require the following new disclosures:

• detailed disclosures of registrants' accounting policies for derivative financial instruments and derivative commodity instruments;
  
• quantitative and qualitative disclosures outside the financial statements about market risk information of derivatives and other financial instruments. The required information includes the fair values of the instruments and contract terms needed to determine expected cash flows for each of the next five years and aggregate cash flows thereafter. This information should be categorized by expected maturity dates. The information should be grouped based on whether the instruments are held for trading or for other purposes and summarized by market risk category, subdivided by specific characteristics within a risk category, such as US dollar/German mark and US dollar/Japanese yen foreign currency exchange risk. The subdivision based on characteristics should be made to the extent it better reflects the market risk for a group of instruments.
  
• forward-looking information, which includes these quantitative and qualitative disclosures outside the financial statements.;
  
• disclosures about the effects of derivatives on other positions.
  

The Rules allow registrants to select one of the following methods to make their quantitative disclosures for market risk sensitive instruments:

• a tabular format --- a presentation of the terms, fair value, expected principal or transaction cash flows, and other information, with instruments grouped within risk exposure categories based on common characteristics;
  
• a sensitivity analysis --- the hypothetical loss in earnings, fair values, or cash;
  
• flows resulting from hypothetical changes in rates or prices;
  
• value-at-risk --- a measure of the potential loss in earnings, fair values, or cash;
  
• flows from changes in rates or prices.

A registrant that holds nonderivative financial instruments that have material amounts of market risk, such as investments, loans, and deposits, is required to make the qualitative and quantitative disclosures of market risk, even though the registrant may hold no derivatives.

The new Rules are effective for filings that include financial statements for fiscal periods ending after June 15, 1997. However, for registrants that are not banks or thrifts and that have a market capitalization of $2.5 billion or less on January 28, 1997, the effective date for the quantitative and qualitative disclosures outside the financial statements about market risk is delayed one year.

Registrants are required to provide summarized quantitative market risk information for the preceding fiscal year. They should explain the reasons for material quantitative changes in market risk exposures between the current and preceding fiscal years in sufficient detail to enable investors to determine trends in market risk information.

For a reference on SEC disclosure rules, see T.J. Linsmeir and N.D. Pearson, "Quantitiative Disclosures of Market Risk in the SEC Release," Accounting Horizons, March 1997, 107-135.  One of my student's projects is summarized below: 

Joseph F. Zullo For his relational database project in Microsoft Access that disaggregates and then aggregates various types of risk on interest rate swaps, click on http://www.resnet.trinity.edu/users/jzullo/title.htm
The heart of this project is a relational database. The term project topic was "suggested aids for using emerging technologies in measuring and evaluating investment risk." To that end, I created a relational database that is able to track the use of derivative instruments and assign risk to individual contracts.   The creation of the database is an attempt at dissaggregated reporting. Theoretically, an investor could access the database through the Internet and compute custom reports and evaluate individual measures of risk associated with each derivative. The benefit of dissaggregated reporting lies in the investor’s ability to perform the aggregation of relevant data. In today’s environment, investors have to rely on annual financial statements of a company to acquire relevant information. The financial statements of a company do not always provide a complete picture of the financial condition of the company. Notably, off-balance sheet items such as derivative financial instruments do not appear in the body of the financial statements. The FASB and the SEC have made strides to overcome this reporting deficiency with pronouncements that require more informational disclosures in the financial statements.

Roger Debreceny wrote the following message on July 31, 1998:

Further to previous discussion on derivatives:

KPMG Handbook Offers Guidance on New Accounting Standards for Derivatives NEW YORK, July 27 /PRNewswire/ -- A comprehensive Derivatives and Hedging Handbook was published today by KPMG Peat Marwick LLP, the accounting, tax and consulting firm, in response to the new accounting standard for derivative instruments and hedging activities issued on June 15, 1998 by the Financial Accounting Standards Board (FASB).

The FASB issued the new standard (Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities) to replace the rules that had been in effect since 1984.

"The estimated worldwide amount of derivative instruments is well above $60 trillion," said Michael A. Conway, partner-in-charge, KPMG Department of Professional Practice." We developed this handbook because the new standard is so complex and the potential impact on commercial companies and financial institutions is enormous.

"Implementing this standard may require changes in hedging strategies and accounting systems, with possible significant effects on financial statements," said Conway. "Therefore, we believe it’s important for organizations to immediately begin evaluating the impact of the standard on their operations and financial reporting. This handbook is designed to make that assessment easier."

The primary author of the handbook, Stephen Swad, KPMG partner, Department of Professional Practice, said that companies must consider several key issues, including:

recognizing all derivative instruments as either assets or liabilities measured at fair value; designating all hedging relationships anew; measuring transition adjustments that will affect earnings; and modifying accounting, risk management objectives and strategies, and information systems to comply with the requirements of the standard. The 425-page publication, the second in KPMG’s handbook series, provides over 100 examples illustrating some of the complex areas of the standard, and answers possible questions that might arise during implementation.

KPMG’s Web site is: http://www.us.kpmg.com.

Dynamic Portfolio Management =

a technique of assessing the risk and managing a portfolio or group of assets and liabilities. Dynamic management is characterized by continuous assessment and periodic adjustment of the portfolio components.  See the discussion of macro hedges under hedge.

Effectiveness =  see ineffectiveness.

Embedded Derivatives =

Portions of contracts that meet the definition of a derivative when the entire contract cannot be considered a financial instruments derivative. Embedded derivatives are discussed in SFAS 133, pp. 7-9, Paragraphs 12-16. Also see Paragraphs 51, 60, 176-178, and 293-311. The overall contract is sometimes referred to as a "hybrid" that contains one or more embedded derivatives. Paragraph 10 notes that interest only strips and principal only strips are not subject to SFAS 133 accounting rules under conditions noted in Paragraph 10. In Paragraph 15, it is noted that embedded foreign currency derivatives "shall not be separated from the host contract and considered a derivative instrument."   See embedded option.

Embedded Option = an option that is an inseparable part of another instrument. Most embedded options are conversion features granted to the buyer or early termination options reserved by the issuer of a security. A call provision of a bond or note that contractually allows for early extinguishment is an example of an embedded option.   See embedded derivatives and option.

Exposed Net Asset Position =

the excess of assets that are measured or denominated in foreign currency and translated at the current rate over liabilities that are measured or denominated in foreign currency and translated at the current rate.

Exposure Draft 162-B =

a part of history in the Financial Accounting Standards Board leading up to SFAS 133. See the Background Information section in SFAS 133, pp. 119-127, Paragraphs 206-231. Especially note Paragraphs 214, 360-384, and 422-194.  See SFAS 133.

Fair Value =

the estimated best disposal (exit, liquidation) value in any sale other than a forced sale. The Financial Accounting Standards Board (FASB) requires estimation of fair value for many types of financial instruments, including derivative financial instruments. The main guidelines are spelled out in SFAS 107.    According to the FASB, fair value is the amount at which an asset (liability) could be bought (incurred) or sold (settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and should be used as the basis for the measurement, if available. If a quoted market price is available, the fair value is the product of the number of trading units times that market price.

If quoted market prices are not available, the estimate of fair value should be based on the best information available in the circumstances. The estimate of fair value should consider prices for similar assets and liabilities and the results of valuation techniques to the extent available in the circumstances. Examples of valuation techniques include the present value of estimated expected future cash flows using a discount rate commensurate with the risks involved, option-pricing models, matrix pricing, option-adjusted spread models, and fundamental analysis. Valuation techniques for measuring assets and liabilities should be consistent with the objective of measuring fair value. Those techniques should incorporate assumptions that market participants would use in their estimates of values, future revenues, and future expenses, including assumptions about interest rates, default, prepayment, and volatility.

The fair value of foreign currency forward contracts should be based on the change in the forward rate and should consider the time value of money. In measuring liabilities at fair value by discounting estimated future cash flows, an objective is to use discount rates at which those liabilities could be settled in an arm's-length transaction. Although the FASB  does not give very explicit guidance on estimation of a derivative’s fair market value, this topic appears at many points in SFAS 133. See Paragraphs 312-319 and 432-457.See blockage factor and yield curve.

Fair Value Hedge =

a hedge that bases its periodic settlements on changes in value of an asset or liability. This type of hedge is most often used for forecasted purchases or sales. See SFAS 133 Paragraphs 20-27,104-110, 111-120, 186, 191-193, 199, 362-370, 422-425, 431-457, and 489-491. See hedge and hedge accounting.

FASB = see SFAS 133.

Financial Accounting Standards Board (FASB) = see SFAS 133.

Financial Instrument =

cash, evidence of an ownership interest in an entity, or a contract that both:

Firm Commitment =

an agreement with an unrelated party, usually legally enforceable, under which performance is probable because of a sufficiently large disincentive for nonperformance. All significant terms of the exchange should be specified in the agreement, including the quantity to be exchanged and the fixed price. Firm commitments differ from long-term purchase commitments. Generally long-term purchase agreements such as agreements to purchase timber of trees not yet planted or oil not yet pumped from the ground can usually be broken with a relatively small amount of penalty equal to damages sustained in the breaking of a contract. A firm commitment usually entails damage awards equal to or more than the contractual commitment. Hence they are less likely to be broken than purchase commitments. Firm commitments are discussed at various points in SFAS 133. See Paragraphs 37, 362, 370, 437-442, and 458-462.. Also see forecasted transaction.

Fixed to Floating Note = see floater.

Floater =

a variable coupon (nominal) rate that determines the interim cash flows on bond debt and bond investments.   Example 12 in SFAS 133 Paragraph 178 illustrates an inverse floater where the coupon rate varies with changes in an interest rate index such as the prime rate or LIBOR.  Example 13 in Paragraph 179 illustrates a levered inverse floater that varies indirectly rather than directly with an index.  Example 14 in Paragraph 180 illustrates a delivered floater that has a lagged relation to an index.   Example 15 in Paragraph 15 illustrates a range floater with a cash payment based upon the number of days that the referent index stays with a a pre-established collar (range).  Example 16 illustrates a ratchet floater that has an adjustable cap and floor that move in relation to a referent index such as LIBOR.  Example 17 in Paragraph 183 illustrates a fixed-to-floating floater varies between fixed rate periods versus floating rate periods. 

Forecasted Transaction =

Foreign Currency Financial Statements =

financial statements that employ foreign currency as the unit of measure.

Foreign Currency Futures Options = see foreign currency hedge.

Foreign Currency Hedge =

a hedge that manages risks of variations in exchange rates for foreign currencies. For example, companies that have firm commitments to purchase or sell items priced in foreign currencies can hedge against exchange rate losses between the time of the commitment and the time of the transaction. Major sections of SFAS 133 dealing with such hedges include Paragraphs 36-42, 121-126, 162-175, 194-197, and 474-487. . See currency swap, hedge, and hedge accounting.

An example of a foreign currency hedge is a contract for foreign currency options on the Philadelphia Exhange.  On Page C23 of the Wall Street Journal on July 22, 1998, blocks of 62,500 Swiss franc European-style August call options required a payment of 3.58 or $0.0358 per franc plus a strike price of 63 or $0.6300 bringing the total price up to $0.6658 per franc.  Hence, spot price on July 22 was 66.23 or $0.6623 per franc.  Hence, the price need only rise by more than $0.0035 per franc to be in-the-money.  On the Philadelphia Exchange, options on Swiss francs can only be transacted in blocks of 62,500 francs.

It is also possible to buy options on foreign currency futures options.  A futures call option gives the owner the right (but not an obligation) to buy the underlying futures contract at the option contract's strike price.  The Chicago Board of Trade deals in foreign currency futures options.

Foreign Currency Transactions =

transactions (for example, sales or purchases of goods or services or loans payable or receivable) whose terms are stated in a currency other than the entity's functional currency. Foreign currency risks are discussed extensively in SFAS 133. See for example, Paragraphs 71,

Foreign Currency Translation =

the process of expressing amounts denominated or measured in one currency in terms of another currency by use of the exchange rate between the two currencies.

Foreign Operation =

an operation whose financial statements are (1) combined or consolidated with or accounted for on an equity basis in the financial statements of the reporting enterprise and (2) prepared in a currency other than the reporting currency of the reporting enterprise.

Forward Exchange Contract =

an agreement to exchange at a specified future date currencies of different countries at a specified rate (forward rate). An example of a forward contract in SFAS 133 appears in Example 3 Paragraphs 121-126. See forward transacion.

Forward Exchange Rate Agreement (FXA) =

a forward contract on exchange rates.  A FXA is a forward contract to buy/sell a notional amount of foreign currency forward at a contracted price.   See forward transacrtion and forward rate agreement (FRA).

Forward Rate =

the rate quoted today for delivery of a specific currency amount at a specific exchange rate on a specific future date.

Forward Rate Agreement (FRA) =

a forward contract on interest rates.   Loan principals are not exchanged and are used only as notionals to establish forward contract settlements.  These are customized contracts that allow borrowers to hedge future borrowing rates on anticipated loans in the future.  FRA contracts can also be purchased in foreign currencies, thereby affecting currency exchange and interest rate risk managment strategies.  See forward transaction and forward exchange rate agreement (FXA).

Forward Transaction or Forward Contract =

an agreement to deliver cash, foreign currency, or some other item at a contracted date in the future. The key distinction between futures versus forward contracts is that forward contracts are customized and are not traded in organized markets. Unlike with futures contracts, it is very simple to specify exact terms such as the exact notional amount and rate to be applied. In the case of a futures contract, it may be difficult or impossible to find the needed combinations traded in markets. However, since forward contracts are not traded in markets, their value is often very difficult to estimate.

Since forward contracts are individually contracted, often through third party investment banks or brokers, the transactions costs of a forward contract can be high relative to futures contracts. Matters of settlement assurances must be contracted since they do not carry the settlement guarantees of futures contracts.

See SFAS 133 Paragraphs 59a, 93, and 100. An example of a forward contract in SFAS 133 appears in Example 3 Paragraphs 121-126 and Example 10 Paragraphs 165-172.

By way of illustration, currency trading on July 22, 1998 showed the following exchange selling rates among banks in amounts of $1 million or more:

For example, the spot rate is such that in $1 million trades or higher, each British pound exchanges into $1.6435 U.S. dollars.  However, a forward exchange contract reduces that amount to $1.6271 if settled in six months.  In practice, forward contracts are tailor-made for the length or time and amounts to be exchanged.  The above rates serve only as guidelines for negotiation.  See futures contract.

Functional Currency =

the primary currency in which an entity conducts its operation and generates and expends cash. It is usually the currency of the country in which the entity is located and the currency in which the books of record are maintained.

Futures Contract =

an exchange-traded contract between a buyer or seller and the clearinghouse of a futures exchange to buy or sell a standard quantity and quality of a commodity, financial instrument, or index at a specified future date and price. Futures contracts commonly require daily settlement payments (known as the variation margin) for changes in the market price of the contract and often permit or require a final net cash settlement, rather than an actual purchase or sale of the underlying asset. Not all futures contracts are financial instruments derivatives. Futures on commodities, for example, are not necessarily financial instruments related unless qualifying as hedges of anticipated transactions.

By way of illustration, futures trading on July 29, 1998 showed the following exchange futures contract prices per stipulated contract amounts: