CHAPTER 23 - DERIVATIVES - INTEREST SWAP

DERIVATIVES are financial instruments, used by entities, to manage financial risk. It

derives its value to movement of risk. It is a executory contract, not a transaction but
an exchange of promise about future action. It gives on party a contractual right to
exchange financial asset or liability with another party if potentially unfavorable
condition and contractual obligation if potentially favorable.

CHARACTERISTIC OF DERIVATIVE

A. Its value changes in response to change in ‘underlying’ variable

B. Requires no initial net investment or small net investment

C. Readily settled at future date by net cash payment

FINANCIAL RISK arises from change in commodity, change in cash flows and foreign
currency exposure.

By acquiring derivative financial instrument and entity can insured themselves that in
cases where interest rates go up and down gradually, they will only pay the original
interest on their acquired loan.

PRICE RISK - uncertainty about the future price of an asset

CREDIT RISK - uncertainty whether the counterparty or the other party on the
contract will honor the terms of the contract. Commonly banks and other financial
institutions are much expose to this type of risk.

INTEREST RATE RISK - uncertainty about future interest rates and their impact on
cash flows and fair value of the asset.
FOREIGN CURRENCY RISK - uncertainty about the Philippine peso cash flows
stemming from assets and liabilities denominated in foreign currency.

HEDGING - designating one or more hedging instruments so that the change in fair
value is only and offset. It means that hedging reduces the risk of paying more. Three
(3) types of hedging namely; fair value hedge, cash flow hedge, and hedge pf a net
investment in a foreign operation.

HEDGE INSTRUMENT - derivative whose fair value and cash flows would be
expected to be offset.

HEDGE ITEM - asset, liability, firm commitment, high probable forecast transaction or
net investment in foreign operation.

MEASUREMENT OF DERIVATIVES

All derivatives and measured at FAIR VALUE.

Changes in fair value is recognized in P/L

NO HEDGING DESGINATION - speculation

FAIR VALUE HEDGE - hedge item is not adjusted, fair value adjustment

Changes in fair value is recognized in OCI

CASH FLOW HEDGE - Variability in cash flow, fair value no adjustment.

EXAMPLES OF DERIVATIVES

A. Interest Swap

B. Forward Contract

C. Future Contract
D. Option

DERIVATIVES FINANCIAL INSTRUMENT AND PRIMARY FINANCIAL

INSTRUMENT ARE SEPARATE STAND ALONE INSTRUMENTS.

INTEREST SWAP

The situation of this derivative is that you have a primary debt and you want to have
the constant amount of interest expense to be paid timely until the maturity date. In
order to achieve the goal, you bind yourself to an secondary financial instrument
where the interest in the future goes higher than the primary, the secondary will have
to pay the excess interest expense. On the contrary, if the rate decreases, you will
pay the deficiency of the normal amount to the secondary instrument.

Illustration 1

On January 1, 2019, Jacs Company entered into a two year P45 000 000 variable
interest rate loan at the prevailing interest rate of 15%. In 2020, the interest rate is
equal to the prevailing interest rate at the beginning of the year. The principal loan is
payable on Decemeber 31, 2020 and the interest is payable on December 31
each year.

On January 1 , 2019, the entity entered into a “receive variable, pay fixed” interest
swap agreement with a speculator bank. The interest swap agreement is designated
as a cash flow hedge
If the prevailing interest on 2020 is 20%. \

Journal entries

2019

Jan 1 Cash 45 000 000

Loan payable 45 000 000

Dec 31 Interest expense 6 750 000

Cash 6 750 000

Interest expense if always computed as principal X current market rate

Interest swap receivable 1 867 500

Unrealized gain 1 867 500

Interest Swap receivable is computed as

Primary Rate 15%

New Rate next yr 20%

Change in rate 5% <-- results into a receivable since 20% >

15%

X Principal Amount P45 000 000

2 250 000

X Present Value of Annuity 0.83 @20% future rate

Interest swap receivable 1 867 500

2020
Dec 31 Interest expense 9 000 000

Cash 9 000 000

Cash 2 250 000

Interest swap receivable 1 867 500

Unrealized gain 382 500

Note that on the year of payment of the principal, the unrealized gain/loss in a
balancing figure to complete the interest expense to be reverse or add.

Unrealized gain 2 250 000

Interest Expense 2 250 000

Loan Payable 45 000 000

Cash 45 000 000

Illustration 2

On January 1 2019, Johnjohn Company borrowed P5 000 000 from the bank at a
variable rate of interest for four years. Interest will be paid annually to the bank on
December 31 and principal due on December 31, 2022. Under the agreement, the
market rate of interest every January resets the variable rate for that period and the
amount of interest to be paid on December 31. In conjunction with the loam, the entity
entered into a “receive variable, pay fixed” interest swap rate agreement with another
bank speculator. Cash flow hedge in the designated interest rate swap agreement.
Market rates of interest are 13%, 14%, 12% and 15% for 2019, 2020, 2021, and 2022
respectively.

Journal entries

2019

Jan 1 Cash 6 000 000

Loan payable 6 000 000

Dec 31 Interest expense 780 000

Cash 780 000

Interest expense if always computed as principal X current market rate

Interest swap receivable 139 200

Unrealized gain 139 200

Interest Swap receivable is computed as

Primary Rate 13%

New Rate next yr 14%

Change in rate 1% <-- results into a receivable since 14% >

13%

X Principal Amount P6 000 000

60 000

X Present Value of Annuity 2.32 @14% future rate, 3 yrs

Interest swap receivable 139 200

2020

Dec 31 Interest expense 840 000

Cash 840 000

Cash 60 000

Interest swap receivable 60 000

Cash to be receive or paid is the difference of the original interest expense and the
current interest expense

Unrealized gain 60 000

Interest Expense 60 000

The amount in this deductible to the unrealized gain/loss is equal to the amount of
cash paid or received.

Unrealized gain 79 200

Interest swap receivable 79 200

Reverse the unrealized gain since the future market interest rate will decrease below
the original interest rate that will result to unrealized loss, then cancel out the balance
of the unrealized gain, then establish the unrealized loss for the next year.

Unrealized loss 101 400

Interest swap payable 101 400

Interest Swap payable is computed as

Primary Rate 13%

New Rate next yr 12%

Change in rate 1% <-- results into a payable since 12% <

13%
X Principal Amount P6 000 000

60 000

X Present Value of Annuity 1.69 @12% future rate, 2 years

Interest swap payable 101 400

2021

Dec 31 Interest expense 720 000

Cash 720 000

Interest swap payable 60 000

Cash 60 000

Interest Expense 60 000

Unrealized Loss 60 000

Interest swap payable 41 400

Unrealized Loss 41 400

Reverse the unrealized loss since the future market interest rate will increase above
the original interest rate that will result to unrealized gain, then cancel out the balance
of the unrealized loss, then establish the unrealized gain for the next year.
 Interest swap payable 104 400

Unrealized gain 104 400

Interest Swap receivable is computed as

Primary Rate 13%

New Rate next yr 15%

Change in rate 2% <-- results into a receivable since 15% >

13%

X Principal Amount P6 000 000

120 000

X Present Value of Annuity .87 @14% future rate, 3 yrs

Interest swap receivable 104 400

2022

Dec 31 Interest expense 900 000

Cash 900 000

Cash 120 000

Interest swap receivable 104 400

Unrealized gain 15 600

Note that on the year of payment of the principal, the unrealized gain/loss in a
balancing figure to complete the interest expense to be reverse or add.
 Unrealized gain 120 000

Interest Expense 120 000

Loan Payable 6 000 000

Cash 6 000 000

Illustration 3

January 1 2019. Attitude Company borrowed P15 000 000 from a Gio Bank at a
variable rate of interest for four years. Interest will be paid annually to the bank in
December 31 and the principal is due on December 31 2022. Under the agreement,
the market rate of interest on each January 1 resets the variable rate for that period
and the amount of interest to be paid on December 31. To protect itself from
fluctuation in interest rate, the entity hedge the variable interest by entering into a
four-year “receivable variable, pay fixed” interest rate swap with a speculator. The
interest swap is based on the notional amount of P15 000 000 and a fixed 7% fixed
rate. This agreement means that the entity will receive a swap payment from the
speculator if the market rate in January 1 is more than 7% and will make a swap
payment to the speculator if the market rate on January 1 is lower than 7%. the
market interest rate are 7%, 12%, 14% and 17% for 2019, 2020, 2021, 2022
respectively.
2019

Jan 1 Cash 15 000 000

Loan payable 15 000 000

Dec 31 Interest expense 1 050 000

Cash 1 050 000

Interest expense if always computed as principal X current market rate

Interest swap receivable 1 800 000

Unrealized gain 1 800 000

Interest Swap receivable is computed as

Primary Rate 7%

New Rate next yr 12%

Change in rate 5% <-- results into a receivable since 12% >

7%

X Principal Amount P15 000 000

750 000

X Present Value of Annuity 2.40 @12% future rate, 3 yrs

Interest swap receivable 1 800 000

2020

Dec 31 Interest expense 1 800 000

Cash 1 800 000

Cash 750 000

 Interest swap receivable 750 000

Cash to be receive or paid is the difference of the original interest expense and the
current interest expense

Unrealized gain 750 000

Interest Expense 750 000

The amount in this deductible to the unrealized gain/loss is equal to the amount of
cash paid or received.

Interest swap receivable 682 500

Unrealized gain 682 500

Interest Swap receivable is computed as

Primary Rate 7%

New Rate next yr 14%

Change in rate 7% <-- results into a receivable since 14% >

7%

X Principal Amount P15 000 000

1 050 000

X Present Value of Annuity 1.65 @14% future rate, 2 yrs

Interest swap receivable 1 732 500

Balance 2019 1 800 000

2020 recognized (750 000)

Balance 2020 1 050 000

Int. Swap Rec. Cumulative, 2020 1 732 500

Balance, 2020 (1 050 000)

To be recognized 682 500

2021

Dec 31 Interest expense 2 100 000

Cash 2 100 000

Cash 1 050 000

Interest swap receivable 1 050 000

Unrealized gain 1 050 000

Interest Expense 1 050 000

Interest swap receivable 592 500

Unrealized gain 592 500

Interest Swap receivable is computed as

Primary Rate 7%

New Rate next yr 17%

Change in rate 10% <-- results into a receivable since 17% > 7%

X Principal Amount P15 000 000

1 500 000

X Present Value of Annuity 0.85 @14% future rate,

Interest swap receivable 1 275 000

Balance 2020 1 732 500

2021 recognized (1 050 000)

Balance 2021 682 500

Int. Swap Rec. Cumulative, 2020 1 275 000

Balance, 2020 (682 500)

To be recognized 592 500

2022

Dec 31 Interest expense 2 550 000

Cash 2 550 000

Cash 1 500 000

Interest swap receivable 1 275 000

Unrealized Gain 225 000

Unrealized gain 1 500 000

Interest Expense 1 500 000

Loan Payable 15 000 000

Cash 15 000 000