2

An Introduction to the
Derivative Instruments
Before addressing the hedge accounting implications of the most common hedging strategies,
it is helpful to examine the derivative instruments used in these strategies. Each derivative
portrayal shown in this chapter is divided into two parts: a first part describing the instrument
and a second part highlighting its accounting implications under IAS 39. Readers who are
already familiar with the hedging instrument are suggested to skip the first part.
The accounting implications mentioned herein are a summary. A more detailed explanation
can be found in the numerous cases provided in this book. We would like to warn the reader
that IFRS accounting is not clear for structured transactions, and that its interpretation can
elicit a broad range of responses. The accounting considerations set out herein are based on
the authors interpretation of the current rules. The reader should also bear in mind that these
rules may be subject to change. In our experience advising multinationals, we have frequently
found that interpretations that are adequate to one auditor may not be acceptable to another.

2.1 FX FORWARDS
2.1.1 Product Description
An FX forward is the most common and the simplest hedging instrument in the FX market.
It is a contract to exchange a fixed amount of one currency for a fixed amount of another
currency. Let us assume that ABC is a European company that expects to purchase a USD
100 million machine from a US supplier. The purchase is expected to be paid in USD on
30 June 20X5. As a result, ABC is exposed to an appreciation of the USD relative to the EUR.
To hedge this exposure ABC enters into a FX forward with the following terms:
FX Forward Terms
Start date
Counterparties
Maturity
ABC buys
ABC sells
Forward Rate
Settlement

1 January 20X5
Company ABC and XYZ Bank
30 June 20X5
USD 100 million
EUR 80 million
1.2500
Physical delivery

The FX forward locks-in the exchange rate at which ABC will buy the USD 100 million: ABC
knows that on 30 June 20X5 will buy the USD at an exchange rate of 1.2500, no matter what
the USD/EUR exchange rate ends up being on that date (see Figure 2.1). This 1.2500 forward
rate is the USD/EUR expected rate for 30 June 20X5, so no premium is paid by any of the two
counterparties at the beginning of the transaction.