Module 3

Accounting for Derivatives

- nature; examples (financial futures, financial forward contracts, options, foreign
currency futures, interest swaps)

INTRODUCTION
This module will include understanding of Accounting for derivatives- nature;
examples (financial futures, financial forward contracts, options, foreign currency
futures, interest swaps).

Intended learning outcomes:

 At the end of the module, the student must be able to:
 Define and describe derivatives, its nature; examples (financial futures,
financial forward contracts, options, foreign currency futures, interest
swaps)

Derivatives
o Derivatives are financial contracts or other contract with all three of the
following characteristics (PAS 39):
1. Whose value changes in response to changes in a specified interest rate,
security price, commodity price, foreign exchange rate, index of prices or
rates, a credit rating or credit index or other variable (sometimes called the
“underlying”).
2. It requires no initial net investment or an initial net investment that is
smaller than would be required for other types of contracts that would be
expected to have a similar response to changes in market factors.
3. It is settled at a future date.
SWAPS
A swap contract is an arrangement whereby two counter parties contractually
agree to swap or exchange one stream if cash flows for another, over a period of
time.

Types of Swaps
 Interest rate swaps
 Cross-currency swaps

OPTION CONTRACTS
An option is a financial derivative contract that provides the holder the right to
buy or sell an underlying in the future, for a price set today. The price of the
option is separate from the price of the underlying.

Premium – the option price. This is the sum of money that the option buyer pays
the option seller to obtain the “right” being sold in the option.
Time value of the option – this is the difference between the options market price
and its intrinsic value.
Intrinsic value of the option – this is the difference between the current market
price and the option price of the hedge item.
Strike price – the price at which the holder has the option to buy or sell the item.
Option to buy “out of the money” – this exists when the market price is less than
the strike price.
Underlying – the asset, financial instrument or any other basis to which the option
is linked, and from where is value is derived.
Two Basic Types of Options
An option can be either one of the following:
1. Call Option
An option granting the right to buy the underlying.
2. Put Option
An option granting the right to sell the underlying.

FOREIGN CURRENCY OPTION

A foreign currency option gives the holder of the option the right but not the
obligation to trade foreign currency in the future.

Hedging Disclosures
Hedge accounting is one of the more complex aspects of financial instruments
accounting under PAS 39. An entity engage in hedging must disclose, separately
for each type of hedge described in PAS 39.
1. A description of each type of hedge;
2. A description of the financial instrument designated as hedging instruments
and their fair values at the reporting date; and
3. The nature of the risks being hedge.
In the case of cash flow hedges, the reporting entity is to disclose:
1. The periods when the cash flows are expected to occur and when they are
expected to affect profit or loss;
2. A description of any forecast transaction for which hedge accounting had
previously been used, but which is no longer expected to occur;
3. The amount that was removed from equity and included in profit or loss for
the period, showing the amount included in each line item in the income
statement; and
4. The amount that was removed from equity during the period and included
in the initial cost or other carrying amount of a nonfinancial asset or
 nonfinancial liability whose acquisition or incurrence was a hedged highly
probable forecast transaction.

The reporting entity is to disclose separately:

 For fair value hedges, gains or losses
a. From the hedging instrument; and
b. From the hedge item attributable to the hedged risk.

 The ineffectiveness recognized in profit or loss that arises from cash flow
hedges;

The ineffectiveness recognized in profit or loss that arises from hedges of net
investments in foreign operations.

ACTIVITIES/PRACTICE & REFLECTION:

Activity 1: Answer the following questions:

Activity 2:

REFERENCES:
Financial accounting Volume 1 Part 1 2017 edition by Valix, Peralta and Valix
Advanced Financial accounting by Punzalan
Government Accounting by Punzalan and Cardona
Investopedia.com
Wikipedia.com