Professional Documents
Culture Documents
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
Also, on Dec. 1, 2014, Dominador Company entered into the first forward contract to buy $1,000 on
March 1, 2015 for P40.15
- 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.
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.
The journal entries to record the hedged item and hedging instrument are as follows:
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
- 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.
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.
*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
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.
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.
The journal entries to record the hedged item and hedging instrument are as follows:
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
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.
- 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.
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:
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%)
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%)
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.
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.
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.
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
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