Derivatives and

Rey Joseph M. Redoblado

Hedge Accounting 1
Concept Map

Gain Inflow
Derivative Changes in FV

Loss Outflow

Gain
Changes in FV

Loss
Hedge item
Inflow
Changes in CF

Outflow
2
Outline

• What is a derivative and its use?

• What are the common products of derivative? Illustrate each.

• What is hedging and its purpose?

• What is hedge accounting?

• What is fair value hedge? Provide example.

• What is cash flow hedge? Provide example.

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Derivative

• Contract

• No or little value at initial

recognition

• Net settlement will be in the

future date

4
Use of derivative

• Speculate

• Hedge

5
Products of
derivatives

• Forward/Future

• Swap

• Options

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Forward
In finance, a forward contract or simply a forward is a non-standardized
contract between two parties to buy or sell an asset at a specified future time at
a price agreed upon today.

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Forward

8
Forward

9
Forward

10
Forward

Deliver

Pay
100

11
Forward

Deliver

Pay
150

50 50

12
Forward

Deliver

Pay
50

50 50

13
Swap
In finance, a swap is a derivative in which counter-parties exchange cash flows
of one party's financial instrument for those of the other party's financial
instrument.

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 Swap
Small
V Big
V

0.5%
8% 8.5%
V-1% 9.5%
100 M V+1%
100 M 7%

Fixed Variable 15
Option
In finance, an option is a derivative financial instrument that specifies a contract
between two parties for a future transaction on an asset at a reference price
(the strike). The buyer of the option gains the right, but not the obligation, to
engage in that transaction, while the seller incurs the corresponding obligation
to fulfill the transaction.

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Call Option

Buys the share at

120

Wants to buy share at

100 from the public
Receives from
bank 20 for every
share Right to buy share at
100 for 1 each

17
Call Option

Buys the share at 80

Wants to buy share at

100 from the public
Receives
nothing

Right to buy share at

100 for 1 each

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Put Option

Sells the share at 80

to the public

Owns the
share at 100

Wants to sell share at

100 to the public

Receives from
bank 20 for every Right to sell share at
share 100 for 1 each
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Put Option

Sells the share at 120

to the public

Owns the
share at 100

Wants to sell share at

100 to the public

Right to sell share at

100 for 1 each
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Hedging
A risk management technique that involves using one or more derivatives or
any other hedging instrument to offset changes in fair value or cash flows of
one or more assets, liabilities or future transactions.

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Hedge Accounting
A special accounting under hedging activities. Assets or liabilities depart from
their ordinary accounting requirements to meet the hedge objectives. Hedging
activities must be highly effective (80% - 125%) to apply hedge accounting. It
is OPTIONAL.

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Fair Value Hedge
Hedge of exposure to changes in fair value of a recognized asset or liability or
an unrecognized firm commitment that is attributable to a particular risk and
that could affect the profit or loss.

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Fair Value Hedge Accounting

• Hedge instrument is measured at fair value with changes

in fair value recognized in profit or loss.

• If the hedge item is otherwise measured at cost or

amortized cost, the measurement of the hedge item is
adjusted for changes in its fair value attributable to hedge
risk. These changes is recognized in profit or loss.

• If the hedge item is an available-for-sale financial asset,

changes in fair value that would otherwise have would
included in equity are recognized in profit for loss.
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FV Hedge, example
Entity A purchased an AFS at par for 100,000. Changes in fair value
exposed the entity to risk of changes in effective interest rate. If the
effective interest rate goes up, the fair value of the AFS will go down. If
the effective interest rate goes down, the fair value of the AFS will go
up.

To hedge, the Entity A entered into a interest swap with a swap bank,
Bank A. If the effective interest rate goes up, the bank will pay entity. If
the effective interest rate goes down, the entity will pay the bank.

The entity designated the swap as hedge instrument to offset the

changes in the fair value of hedge item. All other requirements are met.

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FV Hedge, example cont.

At the end of year 1, the fair value of the AFS is 120,000.

So, the swap bank will receive the difference of 20,000 from
the entity.

At the end of year 2, the fair value of the AFS is 110,000.

So, the swap bank will pay the difference of 10,000 to the
entity.

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FV Hedge, example cont.

Year 1 Year 2
Income Statement Unrealized loss on swap liability ₱ (20,000)
Unrealized gain on swap liability ₱ 10,000
₱ (20,000) ₱ 10,000

Other Unrealized gain on AFS ₱ 20,000

Comprehensive
Income Unrealized loss on AFS ₱ (10,000)
₱ 20,000 ₱ (10,000)

Comprehensive ₱ 0 ₱ 0
Income

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FV Hedge, example conclusion

Year 1 Year 2
Income Statement Unrealized loss on swap liability ₱ (20,000)
Unrealized gain on AFS ₱ 20,000
Unrealized gain on swap liability ₱ 10,000
Unrealized loss on AFS ₱ (10,000)
₱ 0 ₱ 0

Other
Comprehensive
Income ₱ 0 ₱ 0

Comprehensive ₱ 0 ₱ 0
Income

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Cash Flow Hedge
Hedge of exposure to variability in the cash flows that is attributable to a
particular risk associated with a recognized asset, liability or a highly probable
forecast transaction and that could affect profit or loss.

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CF Hedge Accounting

• Changes in the fair value of the hedge instrument

attributable to the hedge risk are deferred as a separate
component of equity to the extent the hedge if effective
(rather than being recognized immediately in profit or
loss.)

• The accounting for the hedge item is not adjusted.

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CF Hedge Accounting conclusion

• If the hedge of forecasted transaction subsequently results in the

recognition of a non-financial asset or non-financial liability, the entity
has an accounting policy choice of whether to keep deferred gains or
losses in equity or remove them from equity and include them in the
initial carrying amount of recognized asset, liability or firm commitment.

• If the hedge of forecasted transaction subsequently results in the

recognition of a financial asset or financial liability, the deferred gains
and losses continue to be deferred in equity.

• When the hedge item affects profit or loss (e.g. dep'n.), any
corresponding amount previously deferred in equity is released from
equity and included in profit or loss ('recycled').

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CF Hedge, example

Entity B is an exotic seafood restaurant. At the beginning of year 1, it

forecasted that it will need 1,000 kilos of fish for year 2. The entity is now
exposed to risk of changes in price of the fish when it acquired the 1,000
kilos on year 2. The price per kilo is 100 at the beginning of year 1. The
entity would like to lock the price at 100.

So, the entity entered in to a forward contract with a bank stating that if the
price per kilo goes up, the entity will buy the fish from the bank at 100. If,
otherwise, the price per kilo goes down, the entity will sell the fish to the
bank at 100.

The derivative forward contract is designated to hedge the forecast of the

price per kilo the fish. All other requirements are met.

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CF Hedge, example cont.

Price per kilo ₱ 120 Year 1 Year 2

Income Statement Unrealized gain on FC ₱ 20,000
Cost of sale ₱ (120,000)
₱ 20,000 ₱ (120,000)

Other
Comprehensive
Income
₱ 0 ₱ 0

Comprehensive ₱ 20,000 ₱ (120,000)

Income

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CF Hedge, example cont.

Price per kilo ₱ 120 Year 1 Year 2

Income Statement Cost of sale ₱ (120,000)
Unrealized gain on FC ₱ 20,000
₱ 0 ₱ (100,000)

Other Unrealized gain on FC ₱ 20,000

Comprehensive
Income
₱ 20,000 ₱ 0

Comprehensive ₱ 20,000 ₱ (100,000)

Income

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CF Hedge, example conclusion

Price per kilo ₱ 80 Year 1 Year 2

Income Statement Cost of sale ₱ (80,000)
Unrealized loss on FC ₱ (20,000)
₱ 0 ₱ (100,000)

Other Unrealized loss on FC ₱ (20,000)

Comprehensive
Income
₱ (20,000) ₱ 0

Comprehensive ₱ (20,000) ₱ (100,000)

Income

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 Alin ang mas mahirap,
Accounting or love life? 36