Lecture AID Derivatives PDF

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lesson 5- derivatives- interest swaps, forward, future and option contracts...

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LECTURE AID DERIVATIVES Derivatives- It is a financial instrument that derives its value from the movement in commodity price, foreign exchange rate and interest rate of an underlying asset or financial instrument. Examples • Interest rate swap • Forward contract • Futures contract • Option The purpose of derivatives is to manage financial risk. Financial risk may originate from the following resources: A. Change in commodity price B. Change in cash flows C. Foreign currency exposure

Ex. ●

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FOREIGN CURRENCY RISK It is the uncertainty about future Philippine peso cash flows stemming from assets and liabilities denominated in foreign currency. Ex. ● The peso equivalent of the foreign currency loan on the date of maturity will differ from the peso equivalent of the foreign currency loan when it was obtained Characteristics of Derivatives ●

Types of FInancial Risks ● PRICE RISK It is the uncertainty about the future price of an asset. Ex. ● Exposed with this risks from existing assets like investments in trading securities. ● assets to be acquired in the future such as purchase commitments ● Equipment to be imported at a future date CREDIT RISK It is the uncertainty over whether a counterparty or the party on the other side of the contract will honor the terms of the contract. Ex. ● Banks and other financial institutions exposed by granting loans, that possibility of non-payment of the loans. INTEREST RATE RISK It is the uncertainty about future interest rates and their impact on cash flows and the fair value of the financial instruments.

Borrower with a variable-rate loan is exposed by reason of the fluctuation of interest rate in the future Borrower with a Fixed-rate loan is exposed because there is always possibility that interest rate will decrease in the future

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The value of the derivative changes in response to the change in an underlying variable. The derivative requires either no initial net investment or an initial small net investment. The derivative is readily settled at a future date by a net cash payment.

HEDGE ACCOUNTING It means designating one or more hedging instruments so that the change in fair value or cash flows is an offset, in whole or in part, to the change in fair value or cash flows of a hedged item. THREE TYPES OF HEDGING RELATIONSHIP ● FAIR VALUE HEDGE ● CASH FLOW HEDGE ● HEDGE ON A NET INVESTMENT IN A FOREIGN OPERATION HEDGING INSTRUMENT It is a derivative whose fair value or cash flows would be expected to offset changes in the fair value or cash flows of the hedged item. HEDGED ITEM It is an asset, liability, firm commitment, highly probable forecast transaction or net investment in a

foreign operation. Derivatives @ Measurement Either asset or liability at FAIR VALUE NO HEDGING DESIGNATION - PROFIT OR LOSS CASH FLOW HEDGE - It is a derivative that offsets in whole or in part the variability in cash flows from a probable forecast transaction. PROBABLE FORECAST TRANSACTION - It is an uncommitted but anticipated future transaction. CASH FLOW HEDGE A. The derivative on hedging instrument is measured at FAIR VALUE. B. Change in FV is recognized at OCI to the extent that it is effective. C. The ineffective portion is recognized in PROFIT OR LOSS. D. The hedged item is not adjusted to conform with fair value. FAIR VALUE HEDGE -

it is a derivative that offsets in whole or in part the CHANGE IN THE FAIR VALUE OF AN ASSET OR LIABILITY.

A. The derivative on a hedging instrument is measured at FAIR VALUE. B. The hedged item is also measured at fair value in contrast with a cash flow hedge where the hedged items is not adjusted. C. The changes in FV is recognized in PROFIT OR LOSS. Interest Rate Swap - It is a contract whereby two parties agree to exchange cash flows for future interest payments based on a contract of loan. Illust. - On January 1, 2020, Easy Company borrowed P5,000,000 from First Bank at a variable rate of interest rate of interest for two years. The terms of the loan are: ● The principal loan is payable on December

31, 2021. ● The interest is payable on December 31 of each year based on the prevailing interest rate at the beginning of the year. To protect itself from fluctuation in interest rate, on January 1,2020, Easy Company entered into an agreement with Second Bank as a speculator to receive variable interest and to pay a fixed interest based on an underlying interest rate of 10% and notional amount of P5,000,000. PRIMARY FINANCIAL INSTRUMENT CONTRACT OF LOAN DERIVATIVE ● RECEIVE VARIABLE, ● PAY FIXED INTEREST RATE ● SWAP AGREEMENT Illust. The interest rate swap agreement is designated as a cash flow hedge against a variable interest rate which may be increasing over the term of the loan. The interest rates on the loan are: January 1, 2020 10% January 1, 2021 12% If more than 10% - Receive a swap payment from Second bank If less than 10%- Pay a swap payment to Second bank SECOND BANK-DERIVATIVE Net cash settlement Variable rate- Jan. 1, 2021 Underlying interest rate More than UR Net cash settlement - receipt

12% 10% 2% P100,000

FIRST BANK- CONTRACT OF LOAN 12/31/20 Variable interest rate-FB P500,000 Net cash settlement-SB Net interest expense P500,000

Journal Entries

12/31/2021 P600,000 (100,000) P500,000

2020 Jan. 01 Cash

deficiency is paid by Gentle Company to the bank.

5,000,000 Loan Payable Dec. 31 Interest expense 500,000 Cash IRS- receivable 89,300 Unrealized gain-IRS

5,000,000

500,000 89,300

FV of Derivative: P100,000 x 0.893 (12%) = P89,300

Unrealized gain: Reported as a component of OCI - Only recognized in profit or loss in the period when the cash flows occur. Journal Entries 2021 Dec. 31 Interest expense 600,000 Cash 600,000 Cash 100,000 IRS- receivable 89,300 Unrealized gain-IRS 10,700 Loan payable Cash

5,000,000 5,000,000

The forward contract is designated as a cash flow hedge. PRIMARY FINANCIAL INSTRUMENT HIGHLY PROBABLE FORECAST PURCHASE Illust. Market price of tobacco per kilo: December 31, 2020 January 31, 2021 Computation: Market price-December 31,2020 (50,000 x P170) Underlying price (50,000 x P150)

170 175

P8,500,000

P7,500,000 Forward contract receivable-12/31/20 P1,000,000 Market price-January 31,2021 P8,750,000 (50,000 x P175) Underlying price (50,000 x P150) P7,500,000 Forward contract receivable-1/31/21 P1,250,000 Forward contract receivable-12/31/20 P1,000,000 Increase P250,000

Unrealized gain-IRS 100,000 Interest expense 100,000 Forward Contract - It is an agreement between two parties to exchange a specified amount of commodity, security or foreign currency on a specified date in the future at a specified price or exchange rate. Illust. On January 1,2020, Gentle Company expects to purchase 50,000 kilos of tobacco from a supplier on January 31, 2021 at the prevailing market price on such date. Recent market factors indicate that the market price of tobacco per kilo is within the vicinity of P150. To protect itself from the variability of the market price of tobacco, Gentle Company entered into a forward contract with a speculator bank under the following terms. ● If the market price is more than P150, the excess is paid by the bank to Gentle Company. ● If the market price is less than P150 the

Journal Entries 2020 Dec. 31 Forward contract receivable 1,000,000 Unrealized gain-forward contract 1,000,000 2021 Jan. 31 Forward contract receivable 250,000 Unrealized gain-forward contract 250,000 Cash 1,250,000 Forward contract receivable 1,250,000 Purchases 8,750,000 Cash 8,750,000 Unrealized gain-forward contract 1,250,000 Purchases* 1,250,000

*Unrealized gain can be credited to gain on forward contract which is an offset against the cost of goods sold in 2021.

Futures Contract - It is a contract to purchase or sell a

specified commodity at some future date at a specified price. It is a standard contract traded in a futures exchange market and one party will never know who is on the other side of the contract. Option - It is a contract that gives the holder the right to purchase or sell an asset at a specified price during a definite period at some future date. - It requires an initial small payment. - It is a RIGHT and not an obligation. ● Call Option ● Put Option Illust. On December 1, 2020, Stable Company projects a need for 100,000 units of raw material to be purchased at the middle of 2021. The raw material is selling at P50 per unit on December 1,2020. The entity is concerned with the movement of prices of the raw material between December 1,2020 and July 1, 2021. As a protection against the increase in price of the raw material, the entity entered into a call option contract with a financial speculator by paying P50,000 for the option on December 1,2020. The amount of P50 is the underlying and also known as the strike or exercise price. The call option contract is the derivative financial instrument that is designated as a cash flow hedge. PRIMARY FINANCIAL INSTRUMENT HIGHLY PROBABLE FORECAST PURCHASE MARKET PRICE OF THE RAW MATERIAL December 1, 2020 50 (UNDERLYING) December 31, 2020 52 July 1, 2021 55 If the market price is greater than the strike or exercise price, the call option is said to be in the money. ● Lower - OUT OF THE MONEY - DO NOT EXERCISE ● Equal - AT THE MONEY

Receive payment of (100,000 x 5) 500,00 from the speculator to settle the option. Journal Entries 2020 Dec. 1 Call option 50,000 Cash 50,000 Dec. 31 Call option 150,000 Unrealized gain-call option* *reported in OCI FV of option (100,000 x (52-50)) Payment of call option Increase in FV Journal Entries 2021July 1 Call option 300,000 Unrealized gain-call option Cash 500,000 Call option

150,000

P200,000 50,000 P150,000

300,000 500,000

Raw materials purchases 5,500,000 Cash 5,500,000 Unrealized gain- call option 450,000 Purchases 450,000 FV of option (100,000 x (55-50)) Call option Increase in FV

P500,000 200,000 P300,000...