eee. PART II: DERIVATIVES In addition to primary instruments such as receivables, payables and equity instruments, financial instruments also include derivatives such as financial options, futures and forwards, interest Tate swaps and currency swaps, Derivatives are useful for managing risks. They can effectively tranefe the risks inherent in an underlying primary instrument between the Contracting parties without any need to transfer the underlying instruments themselves (either at inception of the contract or even, where cash settled, or termination), The development of powerful computing and communication technology has aided the growth in derivative use. The technology provides new ways to analyze information about markets as well as the Power to process high volumes of payments, DERIVATIVE FINANCIAL INSTRUMENTS Derivatives are financial instruments that “derive” their value on contractually required cash flows from some other security or index. For instance, a contract allowing a company to purchase a particular asset (say gold, flour, or coffee bean) at a designated future date, at a predetermined price is a financial instrument that derives its value from expected and actual changes in the price of the underlying asset. CHARACTERISTICS OF DERIVATIVES A derivative isa financial instrument: 8) whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of Prices or rates, credit rating or credit index, or similar variable (sometimes called the “underlying”); b) that requires no initial net investment or little net investment relative to other types of contracts that have a similar response to changes in market Conditions; and ©) that is settled at a future date. Derivatives are commonly used by investors to spread risk and / or to speculate,ee ae WORKS a HOWIT order to reduce the amount of volatility in th na price for a deal in the present that will, ‘i rifolios, since they 42 86°" 1 49 increase their gains through speculatio, effect, happen in the future, OF stor to gain exposure to a market via a smaller Derivatives cat or ought the actual underlying asset. The most common are outlay than if they rev eraged products in which the investor puts down a smal satu the valve of the underlying asset and hopes to gain by a future rise P in the value of that asset. i vatives i Investors mi ree Ol Derivatives for hedging Companies use derivatives to protect against cost fluctuations by fixing'a price for a future deal in advance. By settling costs in this way, buyers gain protection — known as a hedge — against unexpected rises or falls in, for example, the foreign exchange market, interest rates, or the value of the commodity or product they are buying. For example: A Philippine-based airline company reviews its fuel stock levels and decides that it will need to buy jet fuel for its fleet of planes in ‘threemonths’ time. To protect itself from potential future price increase, it can buy fuel # today’s prices for delivery and payment at a future date. This is known #* forward transaction. The financial instrument is called a futures contract. si the price of fuel then falls instead of rising, the company will be locked int paying a higher price. Derivatives for Speculation ie sures bos sell an asset in the hope-of generating a profit ee Hons, is ji that ar iqud or easily deg” Sone on 8 shortere = Bete eet Notices a company’s share price is its oo shares ata future date," AN OPtion gives a right to the bol If share pri 5 of" price and seling silks ey investor can profit by buying a * fixed trent higher price.Mortgage Markets and) Derivatives m1 If share prices fall, the investor can sell the opti ‘ fraction of the value of the asset itself, option or let it lapse, losing a Typical Examples of Derivatives The most frequently used derivatives are i i dures contracts, options, foreign currency futures Sut contracts, forward and interest rate sw. aps. Futures Contracts A futures contract is an agreement between a seller and a buyer that requires that seller to deliver a particular commodity (say com, gold, or soya beans) at a designated future date, at a predetermined price. These contracts are actively treated on regulated future exchanges and are generally referred to as “commodity futures contract.” When the “commodity” is a financial instrument such a8 a Treasury bill or commercial paper, the agreement is referred to as a financial futures contract. Futures contracts are purchased either as an investment or as a hedge against the risks of future price changes. _ Forward Contracts A forward contract is similar to a futures contract but differs in three ways: : ward contract calls for delivery on @ specific date, © i es a futures contract permits the seller to a pe which specific day within the specified month will ee delivery date (if it gets as far as actual delivery before closed out). is led on 2. Unlike a futures contract, 2 forward usually is not trad a market exchange- 2 not call for does - 3. Unlike a futures contract, a forward cOMPBC! TT derlying a daily cash settlement for price chan s paid only contract. Gains and losses on forward cont ~ when they are closed out.172, Chapter 10 tions op serve igh iter co buy oF sel 0 sume ts holder the Peafied price and. within given tig ently are purchased to hedge exposure to the I Options serve the same purpos ng interest rates: J oa ees of an I are fundamentally different Import, fares tm der has no obligeion to exercise the opin, thous ther hand, the holder of @ futures contract must buy or sl On te ote TE parod unless the contract i closed Ou bef withi delivery comes due- Options give i ij say a Treasury DV period. Options frequ Foreign Currency Futures jominated in the currency of the lender (Japanese yen, Swiss franc, German mark, and so on). When Joans must be repaid in foreign currencies, a new element of risk is introduced. This is because if exchange rates change, the peso equivalent of the foreign currency that must be repaid differs from the peso equivalent of the foreign currency borrowed. Foreign loans frequently are den To hedge against “foreign exchange risk” exposure, some firms buy or sell foreign currency futures contracts. These are similar to financial futures except specific foreign currencies are specified in the futures contracts rather than specific debt instruments. They work the same way to protect against foreign exchange risk as financial futures protect against fair value or cash flow risk. Interest Rate Swaps There are contracts to exchange cash flows as of a specified ee series of speci rs floating ae ified dates based on a notional amount and Over 70% whi @ of derivatives are interest rate swaps. These oon exchany 5 j versa, ered interest payments for floating rate paymen's ae example, supe taneing the underlying principal am ot You envy sero You owe P100,000 on a 10% fixed rate hot 'Y Your neighbor who is also paying 10% on het 100s mortgage, but hers j \ ll will her oan raja floating rate loan, so if market 1° ~ To the contrary, she is envious of YoU"ee Bie Mortgage Markets and Derivatives 173 fearful that rates will rise, increasing her payments. A solution would be for the two of you to effectively swap interest payments using an interest rate swap agreement. The way a swap works, you both would continue to actually make your own interest payments, but would exchange the net cash difference between payments at specified intervals. So, in this case, if market rates (and thus floating payments) increase, you would pay, your neighbor; if rates fall, she pays you. The net effect is to exchange the consequences of rate exchanges. In other words, you have effectively converted your fixed rate debt to floating rate debt; your neighbor has done the opposite. Examples of financial instruments that meet the characteristics of a derivative together with the underlying variable affecting its value are as follows: Underlying Variable (main Type of Contract pricing-settlement variable) Commodity swap Commodity price Commodity futures Commodity price Commodity forward Commodity price Credit swap Credit rating, credit index, or credit price Currency swap (foreign exchange Commodity rates swap) ; Currency futures Commodity rates Currency, forward Commodity rates Equity swap (equity of another Equity prices firm) fais ‘ aise i Equity price (equity of anot Equity forward pees ; Interest rate swap Interest rates Interest rate future linked to Interest rates government debt (Treasury ae rest rates Interest rate forward aie10 474 Chop Interest rates ritten treasury d or pass option (call or put) feck a Purchased of written currency ul Pi oO or written commodity Commodity price ul option . Te a option Equity pt equity of ee Purchased or written stock opti ee Total fair value of the reference Total return swap iva oft ial Instruments That Meet the Characteristics of 4 10.1. Financi tf a a ive Together with the Underlying Variable Affecting Its Derivati Value ILLUSTRATIVE CASES ON DERIVATIVES In order to understand derivatives, consider the following examples. Example I: Forward Contract Assume that a company like XYZ, believes that the price of ABC shares wil eo. substantially in the next three months, Unfortunately, it does hans ce enh stern eetone the sires snday. 7 I a broker for deli in months at a price of P10 per share, eh OA ARNE - “apes Scrat # forward contract, a type of derivative. AS are months, TA Teceived the right to receive 10,000 ABC shares ; ithas an obligation to pay P10 per share at What is the benefit of this derivative contract? today and take delivery i tie mrt e delivery in 4 Z profits Ifthe price goes down, XY21°= XYZ can buy ABC af Price goes up, it expects xy;Mortgage Markets and Derivatives 175 ‘all Option A contract or call option allows the holder to call (purchase ‘ime it the next 12 months 10,000 shares of ABC share at sens of P30 a iu if the call is exercised, it can be settled by payment by the contract issuer to the contract holder of an amount equal to 10,000 times the difference between the market price of ABC share on the call date and the strike price of PSO. Assume that ABC is a publicly traded company with a current market price of P50, The underlying is the share price of ABC share, as the price of this contract will depend on this underlying variable. The notional amount is the 10,000 shares that can be called. The holder can acquire the call contract at a considerably lower cost than that of actually buying the 10,000 shares at PSO per share. Holding the call option contract has the same response to market price changes as does holding the individual shares themselves. This contract need not require the actual transfer of shares upon the contract being exercised. The issuer of the contract can settle with payment of cash in an amount equal to the net gain of the holder. Example 3: Put Option Sampaguita Inc. acquired 1,000 shares of Sunflower Company on January 2, 2014 at a cost of P50 per share. Sampaguita does not plan to sell the shares until mid-2015 at the earliest and therefore classifies this investment as financial asset at fair value/OCI. : Sampaguita, however, does not want to be exposed to possible declines in the fair value of the investment. Sampaguita therefore acquires a put option to Sell.the 1,000 shares at a price of P50 per share on June 30, 201 5. The cost of the put option contract is zero (or minimal). Sampaguita designates the put Contract as a fair value hedging contract for the investment in Sunflower Company.ee 176 Chapter 10 ee ee ber 31, 2014, Sunflower Company common stock ig Assume that on Decent Suppose further that the fair value of the put option trading at P35 per ae 15,000. [This change 1S due to the decline in the ae ae ee yndertyind Lace 1,000 shares.) Under fa Ve easthnces PAS 39, would require that Sampaguita include the following in its income statement: the investment of P15,000 (equal to the The unrealized loss on é decline in fair value per share of P15 times the 1,000 shares). the unrealized gain on the derivative financial Jates to the hedging activity. of P15,000. © The portion of instrument that rel In this particular case, the hedge is fully effective, and the gain on the hedging instrument exactly offsets the loss on.the hedged item. Situation 2. Suippose instead that the fair value of the put option at December 31, 2014,is only P10,000. (There are number of reasons why this might be the case.) In this case, the hedge is not full i i i jon > th i ly effective, and the ineffective portions of tenis are fneinded in net income because the unrealized loss of P15,000 = ol hs lly offset by the unrealized gain of P10,000. The net effect ul to report a loss of P5,000 related to this hedge. If this inys would be an ee hedged, the entire unrealized loss of PI5@@! component of Hehe ee income and reported as 4% ; 3 4 equit Fe investments in securities ate ee accumulated unrealized loss