DERIVATIVES

Purpose of derivatives
Entities use derivative financial instruments to manage financial risk.
Financial risk originates from sources, such as change in commodity price, change in
cash flows and foreign currency exposure.
The reduction of financial loss stemming from the financial risk is the motivating factor in
trading in derivatives.
Actually, derivative financial instruments create rights and obligations that have the
effect of transferring between the parties to the instrument the financial risks inherent in
an underlying primary financial instrument.

Types of financial risk

Price risk is the uncertainty about the future price of an asset.
Entities are exposed to a price risk with respect to existing assets such as
investments in trading securities and assets to be acquired in the future such as
purchase commitments and equipment to be imported at a future date.
Credit risk is the uncertainty over whether a counterparty or the party on the other side
of the contract will honor the terms of the contract.
Banks and other financial institutions are usually exposed to a credit risk by
granting loans to borrowers. There is always the possibility of nonpayment of the
loans.
Interest rate risk is the uncertainty about future interest rates and their impact on
cash flows and the fair value of the financial instruments.

What is a derivative?
A derivative is simply 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.
Actually, a derivative is an executory contract, meaning, it is not a transaction but an
exchange of promises about future action.
On inception, derivative financial instruments give one party a contractual right to
exchange financial asset or financial liability with another party under conditions that are
potentially favorable.
Hedging 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.
Simply stated, hedging is a means of protecting a financial loss or the structuring of
a transaction to reduce risk.

Hedging instrument
A hedging instrument is the 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
A hedged item is an asset, liability, firm commitment, highly probable forecast
transaction or net investment in a foreign operation.
To be designated as hedged item, the hedged item should expose the entity to risk
of changes in fair value or future cash flows.

Examples of Derivatives
The derivatives that are often designated as hedging instruments are:
a. Interest rate swap
b. Forward contract
c. Futures contract
d. Option
e. Foreign currency forward contract

Illustration 1 - Interest rate swap

On January 1, 2016, Easy Company borrowed P5,000,000 from First Bank at a
variable rate of interest for two years.

The terms of the loan are:

a. The principal loan is payable on December 31, 2017.

b. The interest is payable on December 31 of each year based on the

prevailing interest rate at the beginning of the year.

The contract of loan is the primary financial instrument.

To protect itself from fluctuation in interest rate, on January 1, 2016, Easy Company
entered into an agreement with Second Bank as the 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.
This "receive variable, pay fixed interest rate swap" agreement with the Second Bank
is the derivative financial instrument.
This derivative contract means that Easy Company shall receive a swap payment
from the Second Bank based on P5,000,000 if the January 1 interest rate is more
than 10% and will make a swap payment to the Second Bank if the January 1
interest rate is less than 10%.
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, 2016 10%

January 1, 2017 12%

Net cash settlement

The net cash settlement between Easy Company and the Second Bank is the
difference between the variable interest to be received and the 10% fixed interest to
be paid and would appear as follows:
December 31 2016 December 21 2017

Receive variable 500,000 600,000 Pay 10% Fixed -500,000 -500,000

Net Cash settlement
receipt 0 100,000

Another Computation

Variable rate on January 1, 2017 12% Underlying interest rate 10%

Variable rate more than underlying rate 2%

Net cash settlement-receipt (P5,000,000 X 2%) 100,000

The computation means that under the interest rate swap, Easy Company shall
receive P100,000 from Second Bank on December 31, 2017.
With respect to the contract of loan with First bank, observe the following schedule of
interest payments:
31 2016
December
21 2017

December
Variable interest to be paid to First bank 500,000 600,000 Net cash
settlement with Second Bank
receipt 0 -100,000 Net interest expense 500,000 500,000

Note that Easy Company incurs a uniform or fixed interest of P500,000 on a variable
rate loan.

Journal Entries

2016

Jan. 1 Cash 5,000,000

Loan Payable 5,000,000 Dec. 31 Interest expense (P5,000,000

x 10%) 500,000

Cash 500,000

31 Interest rate swap receivable 89,300

Unrealized gain-interest rate swap 89,300

A derivative is recognized at fair value. The fair value is equal to the present value of
P100,000 to be received on December 31, 2017. The present value of 1 for one period
at 12% is.893. Thus, P100,000 times.893 equals P89,300.
The "unrealized gain" on the interest rate swap is a component of other
comprehensive income because the derivative 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.
2017

Dec. 31 Interest expense (P5,000,000 x 12%) 600,000

Cash 600,000

31 Cash 100,000

Interest rate swap receivable 89,300 Unrealized gain- interest rate swap

10,700

This is the swap payment from Second Bank as a result of higher interest rate.
The unrealized gain of P10,700 represents the increase in the fair value of the
interest rate swap receivable due to passage of time.

31 Loan Payable 5,000,000

Cash 5,000,000

31 Unrealized gain- interest rate swap 100,000

Interest expense 100,000

Notice that the net interest expense for 2017 is P500,000 because of the hedging
effect of the interest rate swap.