(MODREV 2)

LECTURE AID

2020
Chapter 12 Basic Derivatives
 

Learning Competencies

• Identify the characteristics of a derivative.

Give examples of derivatives.
• State the purposes of acquiring derivatives.
• Account for derivatives that are not
designated as hedging instruments.
Definition of a derivative

A derivative is a financial instrument or other

contract that derives its value from the changes in
value of some other underlying asset or other
instrument.
Characteristics of a derivative

1. its value changes in response to the change in an

underlying;
2. requires no initial net investment or a very minimal
initial net investment; and
3. it is settled at a future date.
Common types of derivatives

1. Forward contract – is an agreement between two parties to

exchange a specified amount of a commodity, security, or foreign
currency at a specified date in the future at a pre-agreed price.
 

2. Futures contract – is a contract traded on an exchange that

allows an entity to buy or sell a specified quantity of commodity or a
financial security at a specified price on a specified future date.
Common types of derivatives (Continuation)

3. Option – is a contract giving the holder the right, but not the
obligation, to buy or sell an asset at a specified price any time during a
specified period in the future. When the holder exercises his right, the
writer of the option is obligated to perform his obligation on the option
contract.

• Types of options as to right of holder:

1. Call option – an option to buy
2. Put option – and option to sell
 At the money – holder may or may not exercise option; no
gain or loss in exercising
 In the money – holder should exercise; gain in exercising
 Out of the money – holder should not exercise; loss in
exercising
Common types of derivatives (Continuation)

4. Swap – is a contract in which two parties agree to exchange

payments in the future based on the movement of some agreed-upon
price or rate. Common examples include:
• Interest rate swap – is a contract between two parties who agree
to exchange future interest payments on a given loan amount.
Usually, one set of interest payments in based on a fixed interest
rate and the other is based on a variable interest rate.
• Foreign currency swap – is a contract between two parties who
agree to exchange sum of money in one currency for another
currency.
Common types of derivatives (Continuation)

5. Caps, floors and collars – are essentially options designed to shift

the risk of an upward and/or downward movement in variables such as
interest rates. These are normally linked to a notional amount and a
reference rate.

6. Swaption – is an option on a swap. The option provides the holder

with the right to enter into a swap at a specified future date at specified
terms. This derivative has characteristics of an option and a swap.
 
7. Weather derivative – a contract that requires payment based on
climatic, geological or other physical variables.
Purpose of derivatives

1. to speculate (incur risk); or

2. to hedge (avoid or manage risk).
Measurement of derivatives

• All derivatives are measured at fair value. The

accounting for fair value changes depends on whether
the derivative is:
1. Not designated as a hedging instrument;
2. Designated as fair value hedge; or
3. Designated as cash flow hedge.
No hedging designation (held for speculation)

• Derivatives not designated as hedging instrument are

accounted for as held for trading securities.
Accordingly, fair value changes are recognized in profit
or loss (i.e., FVPL).
 CLASSROOM
DISCUSSIONS &
COMPUTATIONS
PROBLEM 12-2: THEORY & COMPUTATIONAL
OPEN FORUM
QUESTIONS????
REACTIONS!!!!!
SEATWORK
(PROBLEM 12-4: CLASSROOM ACTIVITY)