Derivatives and
Hedging
4 October 2016
Derivatives - Interest
Rate Swap
Introduction and Purpose
Types of Financial Risks
Definition of Derivative
Characteristics of Derivatives
Hedging
Measurement of Derivatives
Interest Rate Swap
UNOR - College of Business and Accountancy
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4 October 2016
Slide 2
Introduction and Purpose
Introduction:
Increasingly common but very complicated
Huge losses may be suffered from too much exposure
Potential huge gains or losses - settlement
Purpose:
Manage financial risks
Reduction of financial loss from the financial risk
Creates rights and obligation - transferring between
the parties to the instrument the financial risk inherent
in an underlying primary financial instruments
UNOR - College of Business and Accountancy
4 October 2016
Slide 3
Types of Financial Risks
1. Price risk - uncertainty about the future price of an
asset
2. Credit risk - uncertainty over whether a
counterparty or the party on the other side of the
contract will honor the terms of the contract;
possibility of nonpayment of the loans
3. Interest rate risk - uncertainty about future interest
rates and their impact on cash flows and the fair
value of the financial instruments
a. Variable-rate loan - fluctuation of interest rate in the
future
b. Fixed-rate loan - possibility that the interest rate will
decrease in the future
4 October 2016
4. Foreign currency risk - uncertainty about future
Slide 4
UNOR - College of Business and Accountancy
Definition of Derivative
Derives its value from movement in
commodity price, foreign exchange rate and
interest rate of underlying asset or financial
instrument
Executory contract - exchange of promises
about future action
Give one party a contractual right to exchange
financial asset or financial liability with another
party under conditions that are potentially
favorable; other party has contractual
obligation to exchange under potentially
unfavorable conditions
4 October 2016
UNOR - College of Business and Accountancy
Slide 5
Characteristics of
Derivatives
A derivative is a financial instrument with ALL THREE of the
following characteristics:
1. The value of the derivative changes in response to the
change in an underlying variable.
2. The derivative requires either no initial net investment or an
initial small net investment.
3. The derivative is readily settled at a future date by a net
cash payment.
Underlying specified interest rate, commodity price, foreign
exchange rate, price index and other variable.
Must contain notional (amount of currency, number of shares,
etc.)
UNOR - College of Business and Accountancy
4 October 2016
Slide 6
Hedging
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 the hedged item.
Protecting a financial loss or the structuring of a
transaction to reduce risk.
Three types:
1. Fair value hedge
2. Cash flow hedge
3. Hedge of a net investment in a foreign operation
UNOR - College of Business and Accountancy
4 October 2016
Slide 7
Hedged Item
A hedge items is an asset, liability, firm
commitment, highly probable forecast
transaction or net investment in a foreign
operations
Expose the entity to risk of changes in fair
value or future cash flows
UNOR - College of Business and Accountancy
4 October 2016
Slide 8
Measurement of
Derivatives
Recognize or measure all derivatives as either
assets or liabilities at fair value
Fair value and notional should be disclosed
Will depends whether P&L or OCI
1. The derivative is not designated as a
hedging instrument
2. The derivative is designated as a cash flow
hedge
3. The derivative is designated as a fair value
hedge
UNOR - College of Business and Accountancy
4 October 2016
Slide 9
Measurement of
Derivatives (Contd)
Derivatives not designated as a hedging
instrument shall be recognized in profit or loss
Derivative - speculation
UNOR - College of Business and Accountancy
4 October 2016
Slide 10
Cash Flow Hedge
Offsets in whole or in part the variability in cash flows
from a probable forecast transaction
Forecast transaction is uncommitted bit anticipated
future transaction:
a. The derivative or hedging instrument is measured
at fair value.
b. Change in fair value is recognized as component of
OCI to the extent that the hedge is effective.
c. The ineffective portion is recognize in profit or loss.
d. The hedged item is not adjusted to conform with
fair value.
UNOR - College of Business and Accountancy
4 October 2016
Slide 11
Cash Flow Hedge (Contd)
1. The hedged asset or liability is adjusted to fair
value based on changes in the spot exchange
rate, and a foreign exchange gain or loss is
recognized in net income.
2. The derivative hedging instrument is adjusted
to fair value (resulting in an asset or liability
reported on the balance sheet) with the
counterpart recognized as a change in
Accumulated Other Comprehensive Income
(AOCI).
UNOR - College of Business and Accountancy
4 October 2016
Slide 12
Cash Flow Hedge (Contd)
3. An amount equal to the foreign exchange gain or
loss on the hedged asset or liability is then
transferred from AOCI to net income; the net effect
is to offset any gain or loss on the hedged asset or
liability.
4. An additional amount is removed from AOCI and
recognized in net income to reflect (a) the current
periods amortization of the original discount or
premium on the forward contract (if a forward
contract is the hedging instrument) or (b) the
change in the time value of the option (if an option
is the hedging instrument).
UNOR - College of Business and Accountancy
4 October 2016
Slide 13
Fair Value Hedge
1. Adjust the hedged asset or liability to fair
value based on changes in the spot exchange
rate and recognize a foreign exchange gain or
loss in net income.
2. Adjust the derivative hedging instrument to
fair value (resulting in an asset or liability
reported on the balance sheet) and recognize
the counterpart as a gain or loss in net
income.
UNOR - College of Business and Accountancy
4 October 2016
Slide 14
