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INTRODUCTION
In the past, derivatives were considered off-balance sheet items, meaning they were not separately accounted for in the financial
statements. However, because of the risks inherent in engaging in derivative transactions and their potential for abusive use, reporting
standards now require proper accounting and disclosure of derivatives.
PURPOSE OF DERIVATIVES
The purpose of derivatives is either:
(a) To speculate or incur risk; or
(b) To hedge or avoid/manage risk
The use of derivatives for speculation purposes is generally discouraged because of the high risk associated with. More commonly,
derivatives are used to manage risks, particularly financial risk.
DEFINITION OF DERIVATIVES
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
A derivative is a financial instrument or other contract with all three of the following characteristics:
a. Its value changes in response to the change in an underlying;
b. It requires no initial investment or only a very minimal initial net investment; and
c. It is settled at a future date
An underlying is a specified price, rate or other variable (e.g., interest rate, security or commodity price, foreign exchange rate, index
of prices or rates, etc.), including a scheduled event (e.g., a payment under contract) that may or may not occur.
A notional amount is a specified unit of measure (e.g., currency units, shares, bushels, pounds, etc.). A derivative is an executory
contract, meaning the performance of which is yet to be executed in the future.
A derivative involves exchanges of promises between contracting parties, the future settlement or execution of which depends on
whether the value of an underlying will go up or down.
When derivatives are used to manage risks, the buyer of a derivative instrument forgoes potential gains in exchange for security over
potential losses. Meaning, the entity is better off with no gains than to suffer losses (e.g., playing safe).
Forwards Futures
Forwards are private contracts which are most likely over-the- Futures are traded in a market.
counter (OTC) transactions.
Forwards are private contracts between two private parties who A party in a futures contract may never know the other
interact directly with each other. contracting party because they interact indirectly through a
broker.
Forwards may be settled by the actual delivery of the agreed- Futures are normally settled through net cash payment.
upon commodity or net cash payment.
3. Options – a contract that gives 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. The option buyer will exercise the option only when the option is in the money,
that is, the buyer gains in exercising the option. There are two types of options:
(a) Call option – an option to buy.
(b) Put option – an option to sell.
4. Swap – a contract in which two parties agree to exchange payments in the future based on the movement of some agreed-
upon price or rate.
MEASUREMENT OF DERIVATIVES
All derivatives are measured at fair value.
On December 1, 2019, the company entered into an apple juice concentrate futures contract to purchase 50,000 kilos of concentrate on
February 1, 2020 at a fixed price of P50 per kilo. This futures contract was designated as a cash flow hedge.
The market price of the apple juice concentrate on December 31, 2019 and February 1, 2020 are P60 and P52, respectively.
As a protection against the increase in price of the raw material, the company entered into a call option contract with a speculator by
paying P50,000 for the option on December 1, 2019. The contract gives the company the right to purchase 100,000 units of the raw
material at P50 per unit. The call option was designated as a cash flow hedge.
The market price of the raw material on December 31, 2019 and July 1, 2020 are P52 and P55, respectively.
The principal loan is payable on December 31, 2020 and the interest is payable on December 31 of each year based on the prevailing
interest rate at the beginning of the year.
On January 1, 2019, to protect itself from fluctuation in interest rate, the company entered into a “receivable variable, pay fixed” interest
swap agreement with a speculator bank designated as a cash flow hedge.
The prevailing rate of interest on January 1, 2020 is 14% and the present value of 1 at 14% for one period is 0.877.
Assuming the interest rate on January 1, 2020 is 9% and the present value of 1 at 9% for one period is 0.917.
Problem 4:
On January 1, 2017, Foxx Company borrowed P5,000,000 from a bank at a variable rate of interest for 4 years. Interest will be paid
annually to the bank every December 31 and the principal is due on December 31, 2020. Under the agreement, the market rate of
interest every January 1 resets the variable rate for that period and the amount of interest to be paid on December 31.
In conjunction with the loan, the company entered into a “receive variable, pay fixed” interest rate swap agreement with another bank
speculator. The interest rate swap agreement was designated as a cash flow hedge. The market rates of interest are:
The PV of an ordinary annuity of 1 is 2.32 at 14% for three periods, 1.69 at 12% for two periods and 0.90 at 11% for one period.
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