Characteristics of derivative

Underlying – the rates of prices that relate to the asset or liability underlying the derivative instrument
(exchange rates, interest rates, stock prices, commodity price)
- Their value changes overtime
- the value of the derivative depends on the value of underlying that is why the derivatives
changes its value.
Notional amount – total face amount of the asset or liability that underlies the derivative contracts
- The number of units or quantity that are specified in the derivative instrument
- Examples: number of foreign currency units or quantity such as shares or other units specified in
the financial instrument.
Minimal initial investment – a derivative requires little or no initial investment because it is an
investment in a change in value rather than an investment in the actual asset or liability.
- Cash payments involve our need at the end of the contract
- No initial investment because the payment is at the end of the contract rather than its
inception.
No required delivery – generally the parties to the contract, the counterparties, are not required to
actually deliver an asset that is associated with the underlying.

TYPES OF DERIVATIVES
Forward (or futures) contracts
- A contract to by or sell a specified amount of an asset at a specified fixed price with delivery at a
specified future point in time. OBLIGATION
- If an entity enter into e foreign contract meaning dili na siya pwede mu back out.
Option contract
- Represents a right rather than an obligation to either buy or sell some quantity of a particular
underlying.
Swap agreement
- A type of forward contract represented by a contractual obligation, arranged by an intermediary
that requires the exchange of cash flows between two parties.
- Exchange payments in the future.

USE OF DERIVATIVES
Speculation – involves trading a financial instrument involving high risk, in expectation of significant
returns. The motive is to take maximum advantage from fluctuations in the market.
- We speculate for the changes of value in the underlying overtime.
Hedging – is a way for a company to minimize or eliminate risk.
- To hedge is to take the position opposite of the transaction
TYPES OF HEDGE
Fair value hedge – are those designed to hedge the exposure to potential changes in the fair value of (a)
a recognized asset or liability, or (b) an unrecognized firm commitment for which a binding agreement
exists such as to buy or sell inventory.
- The gains or losses on the hedged asset or liability, and the hedging instrument, are recognized
in current earnings on the income statement.
Cash flow hedge – are those designed to hedge the exposure to potential changes in the anticipated
cash flows, either into or out of the company, for (a) a recognized asset or liability such as future interest
payments on variable-interest debt, or (b) a forecasted cash transaction such as a forecasted purchase
or sale.
- The gain or loss on the derivative instrument initially being reported in OCI.
- Forecasting transaction so normally there is temporarily no hedge item.
- The gain or loss on the effective portion of the hedging instrument should be reported in OCI
- The gain or loss on the ineffective portion is reported in current earnings on the statement of
income.
- However if silent, generally the gain or loss on the derivative instrument shall be taken into the
OCI
HEDGE ITEM TYPES OF HEDGE
Recognized asset or liability Fair value hedge Cash flow hedge
Firm commitment Fair value hedge Cash flow hedge
Highly probable forecasted transaction Cash flow hedge
Net investment in a foreign corporation Cash flow hedge

HEDGING RECOGNIZED ASSET OR LIABILITY

(Buyer’s Point of View) Using Foreign Currency Forward Contracts as a Hedging Instrument.
On Dec. 1, 2014, Dominador Company purchased inventory for US $1,000 payable on March 1, 2015
(i.e., the transaction is payable in dollars:

Also, on Dec. 1, 2014, Dominador Company entered into the first forward contract to buy $1,000 on
March 1, 2015 for P40.15

12/01/2014 12/31/2014 03/01/2015

Spot rate 40.00 40.30 40.20
30-days forward rate 40.05 40.45 40.40
60-days forward rate 40.10 40.40 40.50
90-days forward rate 40.15 40.45 40.60

- Hedge item in this transaction is the exposed liability kay mag import man ug inventory, then
the hedge instrument is the forward contract to buy $1,000 FC.
- Selling spot rate and selling forward rate
- Oblige to pay foreign currency at the settlement date
 - The rate to be used is the number of days remaining until the date of settlement

The journal entries to record the hedged item and hedging instrument are as follows:
Hedged item – Importing Transaction Hedging Instrument – Forward Contracts
(Exposed Liability) (Broad Approach of Gross Accounting)
(Spot Rate) (Forward Rate)
December 1, 2014
Transaction Data Date of inception/hedging of 90 days forwards
Inventory ($1,000 x P40) 40,000 FC Receivable from XD (P40.15 x $1,000) 40,150
Accounts Payable 40,000 Pesos Payable to XD 40,150
To record purchase of goods on account using the To record forward contract to buy $1,000 using forward
spot rate on 2/01/2014 rate.

*XD – exchange dealer

Balance Sheet Presentation on 12/2/2014 In this case the FC receivable from XD absorbs the
FC Receivable from XD 40,150 changes in the exchange rate or the value of the
Less: Pesos Payable to XD 40,150 underlying.
Forward Contract (Fair Value) 0
December 31, 2014
(Balance Sheet Date an intervening financial reporting date)
FC Transaction loss 300 FC Receivable from XD 250
Account Payable 300 FC Transaction Gain 250
(P40.30 – P40.00) $1,000 (P40.40 – P40.15) $1,000
To record a loss on the exposed liability To record a gain on foreign currency to be received
denominated in FC from FC dealer

Balance Sheet Presentation on 12/31/2014 Take note: If the hedge item is liability the
FC Receivable from XD (P40.40 x $1,000) 40,400 hedge instrument is receivable.
Less: Pesos Payable to XD (fixed at P40.15) 40,150 - If the pesos payable is greater than the
Forward Contract (Fair Value Asset) 250 receivable the forward contract in liability.
On March 1, 2015 (the transaction date and the settlement date), the journal entries are:

March 1, 2015
Settlement date Settlement date/date of expiration of contract
Accounts Payable 100 FC Transaction Loss 200
FC Transaction gain 100 FC Receivable from XD 200
(P40.20 – P40.30) $1,000 (P40.40 – P40.20) $1,000
To record a gain from 12/31/14 liability To record a loss on foreign currency to be received
denominated in FC from FC dealer
 March 1, 2015
Settlement Date Settlement Date/Date of Expiration of Contract
Pesos Payable from XD 40,150
Cash 40,150
To record payment to XD
Investment in FC 40,200
FC Receivable from XD 40,200
To record receipt of foreign currency
Accounts payable 40,200 Cash 40,200
Cash 40,200 Investment in FC 40,200
To record payment of accounts payable To record receipt of foreign currency

(Seller’s Point of View) Using Foreign Currency Forward Contracts as a Hedging Instrument

On Dec. 1, 2014, Jose Company sold merchandise for US $1,500 to be collected on March 1, 2015 (i.e.,
the transaction is payable in dollars).

Also on Dec. 1, 2014, Jose Company entered into the first forward contract to sell $1,500 on March 1,
2015 for P41.15.

12/01/2014 12/31/2014 03/01/2015

Spot rate 41.00 41.30 41.20
30-days forward rate 41.05 41.45 41.40
60-days forward rate 41.10 41.40 41.50
90-days forward rate 41.15 41.45 41.60

- Buying spot rate and buying forward rate

- Fixed anf ma receive then mag vary ang payable to XD
- In this case the FC payable from XD absorbs the changes in the exchange rate or the value of the
underlying

The journal entries to record the hedged item and hedging instrument are as follows:

Hedged item - Exporting Transaction Hedging Instrument – Forward Contracts

(Exposed Asset) (Broad Approach of Gross Position Accounting)
December 1, 2014
Transaction Data Date of inception/hedging of 90 days forwards
Accounts receivable 61,500 Pesos Receivable from XD 61,725
Sales ($1,500 x P41.00) 61,500 FC Payable 61,725
To record sale of goods on account using the spot (P41.15 x $1,500)
rate on 2/01/2014 To record forward contract to sell $1,500 using forward
rate.
Balance Sheet Presentation on 12/01/2014
FC Payable 61,725
Less: Pesos Payable to XD 61,725
Forward Contract (Fair Value) 0

December 31, 2014

(Balance Sheet Date an intervening financial reporting date)
Accounts Receivable 450 FC Transaction Loss 375
FC Transaction Gain 450 FC Payable to XD 375
(P41.30-P40.00) $1,500 (P41.40 – P41.15) $1,500
To record gain on the exposed asset denominated To record a loss on foreign currency to be paid to XD
in FC

Balance Sheet Presentation on 12/31/2014

FC Payable to XD (P41.40 x $1,500) 62,100
Less: Pesos Receivable from XD 61,725
Forward Contract (Fair Value-liability) 375

March 1, 2015
Settlement date Settlement date/date of expiration of contract
FC Transaction Loss 150 FC payable to XD 300
Accounts Receivable from XD 150 FC transaction gain 300
(P41.30 – P41.20) $1,500 (P41.40 – P41.20) $1,500
To record a loss from 12/31/14 to 3/1/15 on asset To record a gain on foreign currency to be paid to
denominated in FC FC dealer

March 1, 2015
Settlement Date Settlement Date/Date of Expiration of Contract
Cash 61,725
Pesos Receivable from XD 61,725
To record collection of receivable from exchange
dealer

Investment in FC 61,800 FC payable to XD 61,800

Accounts Receivable 61,800 Investment in FC 61,800
To record collection of A/R To record receipt of foreign currency

What is a firm commitment?

A binding agreement to purchase or sell at a price on a future date.

- There is no actual transaction taking place in a firm commitment, which can be to sell or
purchase something at a future date.
- This means that the purchase/the asset is not recorded until the date of settlement, unlike the
previous transaction in which the asset is already recognized at the date of transaction.
- Only a memo entry is made for the asset during the transaction date.
- Only forward rates are relevant in this case. (date of transaction until the date of settlement)
- There is zero net forex gain/loss in a firm commitment.
- The cumulative change as a hedge item, the subsequent cumulative in the FV of firm
commitment is recognized as a n asset or liability with a corresponding gain or loss recognized
with profit or loss.

Note: if using the same rate for both hedge item and hedge instrument (same amount because of the
same rate): if hedge instrument is gain; hedge item is a loss, if hedge instrument is loss; hedge item is a
gain.

The initial carrying amount of the asset or liability that arises from a firm commitment is adjusted to
include the cumulative change in the fair value of the firm commitment.

- Adjusted to the sales, asset or purchase account at the date of settlement.

Illustration:
HEDGING A FIRM PURCHASE COMMITMENT
Fair Value Hedge – hedging an unrecognized foreign currency firm commitment

On Dec. 1, 2014, Dominador Company contracts to purchase special order goods from New York
Company. The contract meets the requirement of a firm commitment – fair value hedge. Their
manufacture and delivery will take place in 90 days (on March 1, 2015). The contract price is $1,000 to
be paid by March 1, 2015. Thus the transaction date and the settlement date are both March 1, 2015.

Also, on Dec. 1, 2014, Dominador Company entered into the second forward contract in hedging foreign
currency payable commitment with a contract to receive $1,000 in 90 days at the forward rate of
P40.15.

Remember: FV hedge, the changes in gain or loss in exchange rate will be taken in P/L.

12/01/2014 12/31/2014 03/01/2015

Spot rate 40.00 40.30 40.20
30-days forward rate 40.05 40.45 40.40
60-days forward rate 40.10 40.40 40.50
90-days forward rate 40.15 40.45 40.60
Hedged Item – Hedging Instrument – Forward Contracts
(Unrecognized Foreign Currency Firm Commitment) (Broad Approach or Gross Position Accounting)
 December 1, 2014
Date of commitment (Date of issuing the Purchase Date of Inception/Hedging of 90 days
Order) Forwards
No journal entry us required to record the firm FC Receivable from XD 40,150
commitment. The forward contract or designated as a Pesos Payable to XD 40,150
hedge of the firm commitment to purchase inventory (P40.15 x $1,000)
on March 1, 2015. The hedge is accounted for as a fair To record forward contract to buy $1,000
value hedge.

*in this case fix ang payable nga peso pero mag vary ang ma recive nga FC kay mag dpende na sa spot
arte at the settlement date.
*ang mu absorb sa gain or loss kay si FC receivable from XD
*in net gain or loss ang gipangita automatic 0.00

December 31, 2014

(Balance Sheet Date, an intervening financial reporting date)
FC Transaction Loss 250 FC Receivable from XD 250
Firm Commitment 250 FC Transaction Gain 250
(P40.40 – P40.15) x $1,000 (P40.40 – P40.15) $1,000
To record a loss o firm commitment using the To record a gain on FC to be received from FC
change in the forward rate. dealer

Balance Sheet Presentation on 12/31/2014

Assets Liability
FC Receivable from XD (40.40 x $1,000) 40,400 Firm Commitment P250
Less: Pesos to XD (fixed at 40.25) 40,150
Forward Contract (FV) 250

March 1, 2015
Firm Commitment 200 FC Transaction loss 200
FC Transaction gain 200 FC Receivables from XD 200
To record a gain on fair value of firm commitment (P40.40 – 40.20) x $1,000
To record a loss on foreign currency to be received
from exchange dealer.
Pesos Payable 40,150
Cash 40,150
To record payment to exchange dealer
Investment in FC 40,200
FC Receivable from XD 40,200
To record receipt foreign currency.

Inventory (40.20 x $1,000) 40,200 Cash 40,200

 Cash 40,200 Investment in FC 40,200
To record the purchase of inventory for $1,000 at To record conversion of US dollars into cash for
spot rate. purchase of inventory.

Firm Commitment 50 Firm

Inventory 50
To remove the carrying amount of the firm
commitment from the balance sheet and
adjust the initial carrying amount of the
machine that results from the firm
commitment. This treatment is an
accordance with PAS 39 par. 89 b
Commitment
03/01/2015 Gain 200 250 12/31/2014 loss
50 50 3/1/2015 net

Fair Value Hedge – Hedging an Unrecognized Foreign Currency firm Commitment

On Dec. 1, 2014, Jose Company contracts to sell merchandise to a foreign customer located in Boston,
USA for $1,500. The merchandise is expected to cost P55,000 to manufacture and is to be delivered, and
the account is to be settled 90-days later on March 1, 2015.

On Dec. 1, 2014, Jose Company entered into the second forward in hedging foreign currency receivable
commitment with a contract to sell $1,500 in 90 days at the forward rate of P41.15.

12/01/2014 12/31/2014 03/01/2015

Spot rate 41.00 41.30 41.20
30-days forward rate 41.05 41.45 41.40
60-days forward rate 41.10 41.40 41.50
90-days forward rate 41.15 41.45 41.60

The journal entries to record the hedged item and hedging instrument are as follows:

Hedged Item – Hedging Instrument – Forward Contracts

(Unrecognized Foreign Currency Firm Commitment) (Broad Approach or Gross Position Accounting)
December 1, 2014
Date of commitment (Date of issuing the Purchase Date of Inception/Hedging of 90 days
Order) Forwards
No journal entry us required to record the firm FC Receivable from XD 61,725
commitment. The forward contract or designated as a Pesos Payable to XD 61,725
hedge of the firm commitment to purchase inventory (P41.15 x $1,000)
on March 1, 2015. The hedge is accounted for as a fair To record forward contract to buy $1,000
value hedge.
 December 31, 2014
(Balance Sheet Date, an intervening financial reporting date)
Firm Commitment 375 FC Transaction loss 375
FC Transaction 375 FC Payable to XD 375
(P41.40 – P41.15) x $1,000 (P41.40 – P41.15) X $1,000
To record a gain on firm commitment using the To record loss on foreign currency to be paid to
change in the forward rate exchange dealer.

Balance Sheet Presentation on 12/31/2014

Assets Liability
Firm Commitment P375 FC Payable to XD (P41.40 x $1,500) P62,100
Less: Pesos Payable from XD (fixed at P41.15) 61, 725
Forward Contract (fair value-liability) 375

March 1, 2015
FC Transaction Loss 300 FC Payable to XD 300
Firm Commitment 300 FC Transaction Gain 300
(P41.40 – P41.20) $1,500 (41.40 – 41.20) $1,500
To record a loss on firm commitment using the To record a gain on foreign currency to be paid to
change in the forward rate. exchange dealer.
Investment in Fc 61,800 Cash 61,725
Sales ($1,500 x 41.20) 61,800 Pesos Receivable 61,725
To record sale of merchandise to foreign customer To record collection of receivable from exchange
dealer.
COGS 55,000 FC Payable to XD 61,800
Inventory 55,000 Investment in FC 61,800
To record COGS to foreign customer To record the delivery of FC to exchange dealer

Sales 75
Firm Commitment 75
To remove the CA of the firm commitment from
the balance sheet and adjust the firm
commitment against sales

Hedging a Firm Sale Commitment

Firm Commitment
12/31/2014 Gain 375 300 3/1/15 Loss
75 75 3/1/15 Net
Because of the forward contract, the amount of sales is to lock in at a price of P61,725 [P41.15 x $1,500
or ($ 1,500 x P41.20) – P75, firm commitment account)] equal to the forward rate on the date on
inception, P40.15.

The effect of these transactions on the firm’s profitability is as follows:

Sales (P61,800 – P75) or ($1,500 x P41.15) 61,725

Less: COGS 55,000
Gross Profit 6,725

WHAT IS A FORECASTED TRANSACTION?

- Is an anticipated future transaction for which no firm commitment exists
- Examples would be and anticipated sales transaction or an anticipated inventory purchase
A forecasted may subsequently result to recognition of:
- Financial asset/liability (equity investment of loan)
- Non-financial asset/liability (inventory or PPE)
- A forecasted transaction qualifies for cash flow hedge
- Forecasted transactions exposed an entity to a cash flow risk that will affect reported other OCI
Financial asset/liability

- OCI G/L will be reclassified to P/L in the same period(s) which the hedged item affect P/L.
Non-financial asset/liability
- OCI G/L will be reclassified to P/L in the same period(s) which the hedged item affect P/L.
- OCI G/L will be closed to the initial CA of the hedged item.

Cash Flow Hedge – Hedge of a Forecasted Transaction.

On Dec. 1, 2014, Dominador Company expects to purchase a machine for $1,000 in United State on
Marc 1, 2015. The transaction is probable but there is no binding agreement for this purchase and is to
be denominated in dollars. Thus, transaction and settlement for the machine is March 1, 2015. On Dec.
1, 2014, Dominador Comapany entered into the third forward contract to purchase $1,000 on March 1,
2015 for P40.15. Dominador Company designates the forward contract as a hedging instrument in a
cash flow hedge of the exposure to increases in the dollar rate.

12/01/2014 12/31/2014 03/01/2015

Spot rate 40.00 40.30 40.20
30-days forward rate 40.05 40.45 40.40
60-days forward rate 40.10 40.40 40.50
90-days forward rate 40.15 40.45 40.60
Hedge Item Hedge Instrument
12/01/2014 No entry FC Receivable from XD 40,150
Peso Payable` 40,150
(1000*40.15)
12/31/2014 No entry FC Receivable from XD 250
OCI – Exchange gain (B/S) 250
(40.40-40.15)*100
3/01/2015 No entry OCI – Exchange gain (B/S) 200
FC Receivable from XD 200
(40.40-40.20)*1000

Machinery 40,200 Peso Payable to XD 40,150

Cash 40,200 Cash 40,150
(1000*40.20)

OCI – Exchange gain (B/S) 50 Investment in FC 40,200

Machinery 50 FC receivable from XD 40,200
OCI (1000*40.20)
200 250 Cash 40,200
50 Investment in FC 40,200

On Dec. 1, 2019, PERFECT Co. anticipated the purchase of 85,000 units of merchandise from a foreign
vendor. The purchase would probably occur on March 1, 2020 and require the payment of 1,250,000
foreign currencies (FC). On the same day, Perfect Company entered into a 90-day forward contract to
purchase 1,250,000 foreign currencies (FC). The exchange rates on various dates are as follows:

12/01/2019 12/31/2019 03/1/2020

Spot arte P0.40 P0.41 P0.42
30-day forward rate 0.41 0.42 0.43
60-day forward rate 0.42 0.44 0.435
90-day forward rate 0.425 0.45 0.44

The 85,000 units of merchandise was delivered on March 1, 2020. The merchandise was sold on the
following dates:
April 1, 2020 (30%)
June 1, 2020 (70%)

Hedge Item Hedge Instrument

12/01/2019 No entry FC Receivable from XD 531,250
Peso Payable 531,250
12/31/2019 No entry FC Receivable from XD 18,750
OCI-Exchange gain/loss 18,750
(.44-.425)*1250000
3/1/202 No entry OCI-Exchange gain/loss 25,000
FC Receivable from XD 25,000
(.44-.42)*1250000
Inventory 525,000 Peso Payable to XD 531,250
Cash 525,000 Cash 531,250
(1250000*40.2)
Investment in FC 525,000
FC Receivable from XD 525,000
(1250000*.42)
OCI Cash 525,000
25,000 18,750 Investment in FC 525,000
6,250

ALTERNATIVE 1 ALTERNATIVE 2
3/1/2020 Inventory 525,000 Inventory 525,000
Cash 525,000 Cash` 525,000
(1250000*.42) (1250000*.42)

Inventory 6,250
OCI-Exchange gain/loss 6,250
4/1/2020 COGS 159,375 COGS 157,500
Inventory 159,375 Inventory 157,500
(525000+6250)*30% (525000*30%)

COGS 1,875
OCI-Exchange (B/S) 1,875
(6250*30%)
6/1/2020 COGS 371,875 COGS 367,500
Inventory 371,875 Inventory 367,500
(525000+6250)*70% (525000*70%)

COGS 4,375
OCI-Exchange gain (B/S) 4,375
(6250*70%)

Cash Flow Hedge – Hedge of a Forecasted Transaction.

On Dec. 1, 2014, Jose Company expects to sell merchandise for $1,500 in United State on March 1, 2015.
The transaction is probable but there is no binding agreement for this sale and is to be denominated in
dollars. Thus, transaction and settlement for the sale of merchandise is March 1, 2015. Also on Dec. 1,
2014, Jose Comapany entered into the third forward contract to sell $1,500 on March 1, 2015 for
P41.15. Jose Company designates the forward contract as a hedging instrument in a cash flow hedge of
the exposure to increases in the dollar rate.

12/01/2014 12/31/2014 03/01/2015

Spot rate 41.00 41.30 41.20
30-days forward rate 41.05 41.45 41.40
60-days forward rate 41.10 41.40 41.50
90-days forward rate 41.15 41.45 41.60

Hedge item Hedge instrument

12/15/2014 No entry Peso Receivable from XD 61,725
FC Payable to XD 61,725
(1500*41.14)
12/31/2014 No entry OCI-Exchange gain (B/S) 375
FC Payable to XD 375
(41.40-41.15)*1500
3/1/2015 No entry FC Payable to XD 300
OCI-Exchange gain (B/S) 300
(41.40-41.20)*1500
Investment in FC 61,800 Cash 61,725
Sales 61,800 Peso Receivable from XD 61,725
(1500*41.2)
FC Payable to XD 61,800
Sales 75 Investment in FC 61,800
OCI-Exchange gain (B/S) 75 (1500*41.2)

OCI
375 300
75 61,725

OPTION CONTARCTS
An options contract gives the holder the opinion of buying (or selling) currency units at a future date at
the contracted ‘strike’ price.

An option gives the holder ‘the right but not the obligation’ to trade the foreign currency in the future.
Premium – the option price. This is the sum of to obtain the ‘right’ being sold in the option.
Strike price – the price at which the holder has the option to buy or sell the item.
Two type of options:
 A ‘put’ option allows for the sale of foreign currency buy the option holder.
 A ‘call’ option allows for the purchase of foreign currency by the option holder.
Foreign currency transactions
Options may be classified as to the likeability of their exercise. If the option is at the money (strike price
equals current market prices), the option is likely to be exercised, bearing no loss on the holder. If the
option is in the money, it is also likely to be exercised, bearing gains on the holder. In a put option, this
is when the strike price is greater than market prices; in a call option, this is when the strike price is less
than market prices. If out of the money, the option is likely not to be exercised, since it would bring
losses to the holder.

Option Spot=Strike Spot>Strike Spot<Strike

Call (buy) At the money In the money Out of the money
Put (sell) At the money Out of the money In the money
The option contract is the hedging instrument. It is not affected by changes in the forward rate, since its
value depends on its current fair value.
Intrinsic value of the option – this is the difference between the current market price and the option
price of the hedge item.
Or Market value (spot rate) vs Strike Price
The value of the option – this is the difference between the options market price or fair value less its
intrinsic value.

Hedged Forex Transactions: Option Contracts

The following format is used for split accounting:

Date #1 (difference) Date #2

Fair value option xx Total gains/losses xx xx
Less: intrinsic value xx Less: Intrinsic value g/l xx xx
Time value xx Time value g/l xx xx

There is only intrinsic value if the option is in the money, otherwise it shall be zero. At the settlement
date, the intrinsic value should always match the fair value of the option, resulting to a zero time value
gains/losses.

The intrinsic value is computed by multiplying the notional amount (the amount of the foreign currency)
by the difference of the strike price and the market price per item.

The change in the FV is total gains/losses on the hedging instrument, to be recorded on profit/loss (if FV
hedge) or other comprehensive income (if cash flow hedge) if the company uses non-split accounting.

In the fair value hedges, both the effective and ineffective portion of the gains/losses go to P/L. in cash
flow/net investment hedges, the effective portion is a component of OCI, while the ineffective portion
goes to P/L.
If problems mention that “the effect of time value gains/losses are excluded in the assessment of hedge
effectiveness’, the company uses split accounting, wherein the FV change is divided into the effective
and ineffective portions.

The change in the intrinsic value is the effective portion of the total. While the change in time value is
the ineffective portion.

The forex gain/loss (I/S) from the hedging activity in this case is equal only to the time value
gains/losses, since the effective portion goes to OCI.

The effective portion is among the components of OCI that gets transferred to P/L. the amount is
transferred if the asset purchased is sold or depreciated, whichever is applicable.

Options – hedging an exposed liability

On Dec. 1, 2014, Jaja Company paid cash to purchase 90-day ‘at-the-money’ call option for 50,000
Thailand baht. The option’s purpose is to protect an exposed liability of 50,000 Thailand baht relating to
an inventory purchase receive on Dec. 1, 2014 and to be paid on March 1, 2015.

12/01/2014 12/31/2014 03/01/2015

Spot rate (market price) P1.20 P1.28 P1.27
Strike price (exercise price) 1.20 1.20 1.20
Fair value of call option 300 4,200 3,500

Hedge item Hedge instrument

12/01/2014 Inventory 60,000 Investment in FC Call Option 300
A/P 60,000 Cash 300
(50000*1.2)
12/31/2014 FC Transaction loss 4,000 Investment in FC Call Option 3,900
A/P 4,000 FC transaction gain 3,900
(1.28-1.20)*50000 (4200-300)

3/1/2015 A/P 500 FC Transaction loss 700

FC Transaction gain 500 700
(1.28-1.27)*50000 (4200-3500)

A/P 63,500 Cash 3,500

Cash 63,500 Investment in FC Call Option 3,500
(50000*1.27)
Fair value hedge of a recognized asset – Put Option
On Dec. 15, 2014, ABC, CO sold goods to a Japanese firm for 1,000,000 yen. ABC CO. was concerned
about the fluctuation in the Japanese yen, so on this date, purchased a foreign currency put option for
P7,500 to sell 1,000,000 yens at P0.47 on January 15, 2015.

Relevant rates are the following:

12/15/2014 12/31/2014 1/15/2015
Spot rate P0.48 P0.49 P0.46
Fair value of put option 7,500 5,000 10,000

Hedge item Hedge instrument

12/15/2014 A/R 480,000 Investment in FC Put Option 7,500
Sales 480,000 Cash 7,500
12/31/2014 A/R 10,000 FC Transaction loss 2,500
Fc Transaction gain 10,000 Investment in FC Put Option 2,500
(.49-.48)*1000000 (7500-5000)
1/1/2015 FC Transaction loss 30,000 Investment in FC Put Option 5,000
A/R 30,000 FC Transaction gain 5,000
(.49-.46)*1000000 (8,000-5,000)

Cash 460,000 Cash 10,000

A/R 460,000 Investment in FC Put Option 10,000
(1000000*.46)

On May 6, 2014, ABC Co. entered into a firm commitment to purchase equipment from a foreign
company for FC 4,000,000 when the exchange rate was FC 40:P1. Payment is due on June 1, 2014.
ABC Co. is concerned about the possible fluctuation in exchange rates, so in this date, ABC Co. entered
into a call option to purchase FC 4,000,000 for P100,000 to a broker. ABC Co. paid P4,000 for the
purchased option. The exchange rate on June 1, 2014 is FC 35:P1.

Hedge item Hedge instrument

Firm Commitment 14,286 FC Transaction gain 10,286
Equipment 114,286
Cash 114,286
Firm commitment 14,286
Equipment 14,286
ASSUMING THE SPOT RATE ON 06/1/2014 IS FC 50:P1
June 1, 2014 Strike 4M/40 100,000
Spot 4M/50 80,000
FV of the option 20,000
Firm Commitment 20,000 FC Transaction loss 4,000
FC Transaction gain 20,000 Investment in FC Call Option 4,000
Equipment 80,000
Cash 80,000

Equipment 20,000
Firm Commitment 20,000
May 6, 2014 No entry Investment in FC Call Option 4,000
Cash 4,000
June 1, 2014 Strike 4M/40 100,000
Spot 4M/35 114,286
FV of the option 14,286

FC Transaction loss 14,286 Investment in FC Call Option 10,286

Firm Commitment 14,286 FC Transaction gain 10,286

Equipment 114,286
Cash 114,286

On Nov. 1, 2013 Word Inc. paid P4,500 to acquire call foreign exchange option for Hk$150,000. The
option is acquired to hedge the 2013 anticipated purchase of merchandise for Hk$150,000. The option
expires on March 30, 2014.
11/1/2013 12/31/2013 3/30/2014
Spot rate P3.48 P3.49 P3.51
Fair value of put option 4500 5500 6000
Strike price 3.47 3.47 3.47
Base on the given data, the following situations can derived:
11/1/2013 12/31/2013 3/30/2014
Intrinsic value 1500 3000 6000
Time value 3200 5500 0
Fair value of put option 4500 5500 6000

Hedge item Hedge instrument

01/01/2013 No entry Investment in FC call Option 4,500
Cash 4,500
12/31/2013 No entry Investment in FC Call Option 1,000
Fc Transaction loss 500
OCI-Exchange gain/loss 1,500
3/30/2014 No entry Investment in FC Call option 500
FC Transaction los 2,500
Inventory 526,500 OCI-Exchange gain/loss 3,000
Cash 526,500
(150,000*3.51)