CHAPTER 13

DERIVATIVES
Forward, futures and
option
Forward contract

- A forward contract is an agreement between two parties to exchange a specified amount

of commodity, security or foreign currency on a specified date in the future at a specified
price or exchange rate.
Illustration
- On January 1, 2020, Gentle Company expected to purchase 50, 000 kilos of tobacco from a supplier. On
January 31, 2021 at the prevailing market price on such date.
Recent market factors indicate that the market price of tobacco per kilo is within the vicinity of P150.
To protect itself from the variability of the market price of tobacco, Gentle Company entered into a
froward contract with a speculator bank under the following terms:
a. If the market price is more than P150, the excess is paid by the bank to Gentle Company.
b. If the market price is less than P150, the deficiency is paid by Gentle Company to the bank.
This contract is the derivative financial instrument and the objective is to assure that Simple Company shall
pay P150 per kilo on January 31, 2021.
The forward contract is designated as a cash flow hedge.
The Primary financial instrument is the highly probable forecast purchase of 50, 000 kilos of tobacco on
January 31, 2021.
Market price of tobacco per kilo
December 31, 2020 170
January 31, 2021 175
Computation
Market price – December 31, 2020 (50, 000 x P170) 8,500,000
Underlying price (50,000 x P150)
7,500,000

Forward contract receivable – December 31, 2020 1,000,000

,
Market price – January 31, 2021 (50,000 x P175) 8,750,000
Underlying price
7,500,000

Forward contract receivable – January 31, 2021 1,250,000

Forward contract receivable – December 31, 2020 1,000,000

Increase in forward contract receivable

250,000
Journal entries
2020
Dec. 31 Forward contract receivable 1,000,000
Unrealized gain-forward contract
1,000,000

2021
Jan. 31 Forward contract receivable 250,000
Unrealized gain – forward contract
250,000
31 Cash 1,250,000

Forward contract receivable

1,250,000
31 Purchases (50,000 x P175) 8,750,000
Cash
8,750,000
31 Unrealized gain – forward contract 1,250,000
Futures contract
• A futures contract is a contract to purchase or sell a specified
commodity at some future date at a specified price.
• A futures contract is a standard contract traded in a futures
exchange market and one party will never know who is on the
other side of the contract.
Illustration
Durable company produces bottled apple juice. Apple juice concentrate is typically purchased and the
sold by the kilo.
The entity uses 50,000 kilos of apple juice concentrate each month.
On December 1,2020, the entity entered into an apple juice concentrate futures contract to purchase
50,000 kilos of concentrate on February 1,2021 at a fixed price of P50 per kilo or P2,500,000.
The contract means that if the price of apple juice is more than P50 on February 1, 2021,Durable
Company will receive a cash payment from the speculator equal to the difference.
If the price is less than P50 on February 1,2021, Durable Company will make cash payment to the
speculator for the difference.
The futures contract is the derivative financial instrument that is designated as a cash flow hedge.
The primary financial instruments is the highly probable forecast purchase of 50,000 kilos of apple juice
concentrate on February 1,2021.

Market price of the apple juice concentrate

December 31, 2020
60
February 1, 2021 52
Computation
Market price – December 31, 2020 (50,000 x 60)
3,000,000
Underlying price (50,000 x 50)
2,500,000
Futures contract receivable – December 31, 2020
500,000

Market price – February 1, 2021 (50,000 x 52)

2,600,000
Underlying price
2,500,000
Futures contract receivable – February 1, 2021
100,000
Futures contract receivable – December 31, 2020
500,000
Journal entries
2020
Dec. 31 Futures contract receivable
500,000
Unrealized gain – futures contract
500,000

2021
Feb. 1 Purchases
2,600,000
Cash
2,600,000
1 Unrealized gain – futures contract 400,000
Futures contract receivable
400,000
1 Cash
Option
• An option is contract that gives the holder the right to purchase or sell an asset at a specified price
during a definite period at some future time.
• A call option gives the holder the right to purchase an asset, and a put option gives the holder the
right to sell an asset.
Illustration 1 - Call option
On December 1,2020, Stable Company projects a need for 100,000 units of a raw material to be purchased at the
middle of 2021.

The raw material is selling at P50 per unit on Dec.1 2020. The entity is concerned with the movement of prices of
the raw material between December 1,2020 and July 1,2021.

As a protection against the increase in price of the raw material the entity entered into a call option contract with a
financial speculator by paying P50,000 for the option on December 1, 2020.

The call option gives the entity the right but not the obligation to purchase 100,000 units of the raw material at P50
per unit.

The amount of P50 is the underlying and also known as the strike or exercise price.

The call option contract is the derivative financial instrument that is designated as a cash flow hedge.

The primary financial instrument is the highly probable forecast purchase of 100,000 units of raw material on
July 1, 2021
Market price of the raw material
December 1, 2020 – underlying 50
December 31, 2020 52
July 1, 2021 55
Journal entries

2020
Dec. 1 Call option
50,000
Cash
50,000

Dec. 31 Call option

150,000
Unrealized gain – call option
150,000

2021
July 1 Call option
300, 000
Unrealized gain – call option
300,000

Fair value of call option on July 1, 2021 (100,000 x P5)

500,000
ll option 300, 000
Unrealized gain – call option 300,000

ir value of call option on July 1, 2021 (100,000 x P5) 500,000

ll option – December 31, 2020 200,000
crease in fair value 300,0

sh 500,000
Call option
w material purchases 5,500,000
Cash (100,000 x P55) 5,500,0
nrealized gain – call option 450,000
Purchases
Embedded derivative
• An embedded derivative is a component of a hybrid or combined contract with the effect that some
of the cash flows of the combined contract vary in a way similar to a stand-alone derivative.
• The interest rate swap, forward contract, futures contract and option are stand-alone derivative
contracts separate from the primary contract

Examples of embedded derivative

1. Equity conversion option in a convertible bond instrument that allows the holder to convert the
bond into shares of the issuer.
2. Redemption option in an investment in redeemable preference share that allows the issuer to
repurchase the preference share.
3. An investment in bond whose interest or principal payment is linked to the price of gold or silver.
Embedded derivative accounted for separately

Bifurcation is the process of separating an embedded derivative from the host contract.

1. A separate instrument with the same terms as the embedded feature would meet the definition of a
derivative.
2. The combined contract is not measured at fair value through profit or loss.
3. The economic characteristics and risks of the embedded feature are not closely related to the
economic characteristics and risks of the host contract.
4. The host contract is outside the scope of PFRS 9.
Host contract within scope of PFRS 9

Simply stated, if the host contract is a financial asset, the embedded derivative is not separated.

Depending on the business model of managing financial asset, the host contract in its entirely is
measured at:

a. Amortized cost
b. Fair value through profit or loss
c. Fair value through other comprehensive income
The End