To Manage Financial Risk: Purpose of A Derivative

CHAPTER
BLUE NOTES
15 S
L
Derivatives 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
Purpose of a Derivative
 to manage financial risk
Characteristic of a Derivative: Types Of Financial Risk:

 must contain an underlying and a notional  price risk
 requires either no initial net investment or an initial investment that is  credit risk
smaller than would be required for other types of contracts that have a  interest rate risk
similar response to change in market factors  foreign currency risk
 readily settled at a future date by a net cash payment
Measurement of Derivatives
 shall be recognized as either assets or liabilities at fair value
 fair value and notional amount shall be fully disclosed
Treatment of Gain or Loss Arising from Change in Fair Value of a Derivative

1. Derivative is not designated as a hedging instrument
 changes in fair value are recognized in profit or loss
2. Derivative is designated as a cash flow hedge
 changes in fair value are recognized as a component of other comprehensive income to the extent that
the hedge is effective
 ineffective portion is recognized in profit or loss
3. Derivative is designated as a fair value hedge
 changes in fair value are recognized in profit or loss
Stand-Alone Derivatives are financial instruments that are separate from the primary financial instruments.
Common Forms Of Stand-Alone Derivatives:

A. Interest rate swap is a contract whereby two parties agree to exchange cash flows for future interest payments
based on a contract of loan
B. Forward contract is a commitment to purchase or sell a specified commodity on a future date at a specified
price. Parties know each other
C. Futures contract is a contract to purchase or sell a specified commodity at some future date at a specified
price. One party does not know the entity of the other party
D. Option 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 time. It is a right not an obligation
Call option – right to purchase
Put option – right to sell
E. Foreign currency forward contract is a contract entered into for protection against foreign currency risk
Theory of Accounts Practical Accounting 1

56 USL Blue Notes Chapter 15 - Derivatives
Embedded Derivative is a component of a hybrid or combined contract that also includes a non-derivative host
contract with the effect that some of the cash flows of the combined contract vary in a way similar to a stand-alone
instrument.
Examples of embedded derivatives:
 equity conversion option in a convertible bond instrument
 redemption option in an investment in redeemable preference share
 investment in bond whose interest or principal payment is linked to the price of gold or silver
Accounting For Embedded Derivative

 embedded derivative shall be separated from the host contract and accounted for like any stand-alone
derivative
Bifurcation is the process of separating an embedded derivative from the host contract
Conditions for bifurcation:
 a separate instrument with the same terms as the embedded derivative would meet the definition of a
derivative
 the combined contract is not measured at the fair value with change in fair value recognized in profit or loss
 the economic characteristics and risks of the embedded feature are not closely related to the economic
characteristics and risks of the host contract
 the host contract is outside the scope of PFRS 9
Hedging is the designating one or more hedging instruments so that their 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 the hedge item.
Components of a Hedging Relationship:

Hedging Instrument
 derivative whose fair value or cash flow would be expected to offset changes in the fair value or cash
flows of the hedge item
Hedging Item
 an asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign
operation
 should expose the entity to risk of changes in fair value or future cash flows
Conditions for Hedge Accounting:

 there is formal designation and documentation of the hedging relationship and the entity's risk management
objective and strategy for undertaking the hedge
 the hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows
attributable to the hedged risk
 the effectiveness of the hedge can be measured reliably
 the hedge is assessed on an ongoing basis and determined actually to have been highly effective throughout
the financial reporting periods for which the hedge was designated
 for a cash flow hedge, a forecast transaction that is the subject of a hedge must be highly probable and must
present exposure to the variation in cash flows that could ultimately affect profit or loss
Practical Accounting 1 Theory of Accounts

Chapter 15 - Derivatives USL Blue Notes 57
Illustrative Problems
1. Interest Rate Swap – Cash Flow Hedge
On January 1, 2014, Solana Co. borrowed P5,000,000 from Tuguegarao Bank at a variable rate of interest for
two years. Interest is payable every December 31 based on prevailing interest at the beginning of the year.
To protect itself from fluctuation, Solana Co. entered into an agreement with Cagayan Bank as speculator to
receive variable interest and pay fixed interest based on underlying interest rate of 10% and notional amount
of P5,000,000.
Interest rates on the loan:

January 1, 2014 10%
January 1, 2015 12%
Computation of the fair value of net cash settlement between Solana Co. and Cagayan Bank.
December 31, 2014 December 31, 2015

Receiv variable 500,000 600,000
Pay fix 10% 500,000 500,000
Net cash settlement - 100,000
On December 31, 2014 the fair value of the derivative is:

100,000 x .893 (PV of 1 for one period at 12%) P89,300
Entry on the books:

Interest rate swap receivable 89,300
Unrealized gain – interest rate swap 89,300
Unrealized gain on the interest rate swap is a component of other comprehensive income because the
agreement is designated as a cash flow hedge. Such unrealized gain is recognized in profit or loss in the period
when the cash flow occurs.
2. Interest Rate Swap – Fair Value Hedge
On January 1, 2014, Solana Co. borrowed P5,000,000 from a bank at a fixed interest rate of 10% payable every
December 31 for three years.
The loan is evidenced by a note. On the same day, the entity entered a receive fixed, pay variable interest rate
swap with a speculator and has designated as a fair value hedge.
Market interest rates:

January 1, 2014 10%
January 1, 2015 12%
January 1, 2016 14%
Theory of Accounts Practical Accounting 1
58 USL Blue Notes Chapter 15 - Derivatives
Computation of the fair value of note payable on December 31, 2014
PV of principal at 12% (5,000,000 x .7972) 3,986,000

PV of fixed annual interest (500,000 x 1.69) 845,000
Fair value of note payable 4,831,000
Carrying value of note payable 5,000,000
Decrease in liability – gain 169,000
Entry on the books:

Note payable 169,000
Gain on note payable 169,000
Loss on interest rate swap 169,000

Interest rate swap payable 169,000
Net cash to be paid to the speculator:

(5,000,000 x 2%) 100,000
PV of an ordinary annuity of 1 at 12% for two periods 1.69
Interest rate swap payable 169,000
The gain on note payable and loss on interest rate swap are recognized immediately in profit or loss because
interest rate swap is designated as fair value hedge.
Practical Accounting 1 Theory of Accounts

To Manage Financial Risk: Purpose of A Derivative

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CHAPTER

Characteristic of a Derivative: Types Of Financial Risk:

Treatment of Gain or Loss Arising from Change in Fair Value of a Derivative

Common Forms Of Stand-Alone Derivatives:

Theory of Accounts Practical Accounting 1

Accounting For Embedded Derivative

Components of a Hedging Relationship:

Conditions for Hedge Accounting:

Practical Accounting 1 Theory of Accounts

1. Interest Rate Swap – Cash Flow Hedge

Interest rates on the loan:

December 31, 2014 December 31, 2015

On December 31, 2014 the fair value of the derivative is:

Entry on the books:

2. Interest Rate Swap – Fair Value Hedge

Market interest rates:

Computation of the fair value of note payable on December 31, 2014

PV of principal at 12% (5,000,000 x .7972) 3,986,000

Entry on the books:

Loss on interest rate swap 169,000

Net cash to be paid to the speculator:

Practical Accounting 1 Theory of Accounts

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