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Management Essay

1268 words - 6 pages

n the late 1990’s Enron held substantial investments in several high-tech companies. Many of these stocks soared in price after their initial public offering, which allowed Enron to report very large gains on its income statement.1 However, the stocks could not be sold and the gains realized in cash because the investments were subject to lock-up agreements.2 Enron’s Chief Financial Officer (CFO) and others realized it was likely these investments would experience significant drops in value before they could be sold, but the investments could not be hedged commercially. Therefore, the CFO designed transactions that would, from an accounting point of view, keep the anticipated losses out of ...view middle of the document...

Nonetheless, insight is provided regarding what Enron was trying to accomplish and, in concept, the strategy used to achieve the desired results. 2.0 Risk Management and Derivatives Used by Enron A complex global economy subjects multinational businesses to financial risks. Among these risks are changes in interest rates, foreign currency exchange rates, stock prices, and commodity prices. Derivatives are financial instruments designed to achieve certain economic results and are often used to help manage risk. A derivative’s value is derived from something else, which is referred to as the “underlying.” The underlying could be the price of a security or commodity, a rate, an index, or the price of another financial instrument. A derivative changes in value as the value of the underlying changes. The most common types of derivatives are futures, forwards, swaps, and options. Enron’s hedging transaction relied primarily on equity swaps, put options on equity investments, and collars, which are option-like instruments. 2.1 Futures and Forwards A futures contract is an exchange-traded legal contract to buy or sell a standard quantity of a commodity, financial instrument, or index at a specified future date or price. Futures, which allow companies to lock-in a future purchase or sales price, are generally used to help protect against changing commodity prices. They trade in standard quantities and for standard time periods. A forward contract is similar to a futures contract except that the ___________________ Readers with comments or questions are encouraged to contact the authors via email.
The Journal of Applied Business Research Volume 19, Number 4
contract is tailored more specifically to the needs of the two parties. A forward is traded over-the-counter, and therefore, is less liquid and more risky than an exchange-traded futures contract involving the same underlying. 2.2 Swaps A swap is an agreement between two parties to exchange cash flows calculated according to different formulas. Although interest rate swaps are the most common type of swap, currency, commodity, and equity swaps also frequently occur.4 In an equity swap, at least one party’s payments are calculated according to the performance of a stock price or index. A total return equity swap sets a strike price such that if the market price of the stock increases above that price, the first party receives the difference from the second party. If the stock price decreases below the strike price, the payment is reversed. To illustrate, assume Company X enters into a total return equity swap with Company Y on 100,000 shares of Company A stock at a strike price of $50 per share whereby on the settlement date Company X pays Company Y if A’s price...

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