DERIVATIVES(PFRS9)
foreign exchange rate, price index and
Purpose:
-to manage financial risks which may originate
from:
a) Change in commodity price
b) Change in cash flows
c) Foreign currency exposure
Types of financial risk
Price risk- uncertainty about the future price
of an asset like investments in trading
securities and assets to be acquired in the
future such as purchase commitments and
equipment to be imported at a future date.
 Credit risk- uncertainty over whether a
counterparty or the other party of the
contract will honor terms such as possibility of
nonpayment of loans of an entity from the
bank.
of an entity from the bank
Interest rate risk- uncertainty about future
interest rates and their impact on cash flows
and their FV of the financial instruments such
as a fixed-rate loan which also exposed to
such risk because of possibility that rate will
decrease in the future.
Foreign currency risk- the uncertainty about
future Philippine peso cash flows stemming
from assets and liabilities denominated in
foreign currency.
Derivative
– a financial instrument that derives its value
from the movement in commodity price,
foreign exchange and interest rate of an
underlying asset or financial instrument.
−An executory contract, not a transaction but
an exchange of promise about future action.
-simply, parties to the derivative financial
instrument are taking bets on what will
happen to the underlying financial instrument
in the future.
Characteristics:
1. The value of the derivative changes in
response to the change in an
“underlying” variable. – is a specified
interest rate, commodity price,
other variable.
Derivative must contain a notional-an
amount of currency, no. of shares, or
units or volume.
2. Requires either no initial net
investment or initial small net
investment
3. Readily settled at a future date by a
net cash payment
Hedging- designating one or more hedging
instruments so that the change in FV or cash
flows is an offset, in whole or in part, to the
change in FV or cash flows of a heged item.
-a means of protecting a financial loss or the
structuring of a transaction to reduce risk.
Hedging instrument-the derivative whose FV
or cash flows would be expected to offset
changes in the FV or cash flows of the hedged
item
Hedged item- an asset, liability, firm
commitment, highly probable forecast
transaction or net investment in a foreign
operation
-should expose the entity to risk of changes in
FV or future cash flows.
MEASUREMENT of Derivative:
-all derivatives either asset or liability at FV
-both FV and notional shall be fully disclosed.
- unrealized gain or loss is recognized when
there is change in the FV
Whether the change in FV is recognized in P/L
or in OCI depends on :
a) The derivative is not designated as a
hedging instrument
b) The derivative is designated as a cash
flow hedge
c) The derivative is designated as fair
value hedge.
Changes in FV of a derivative that is not
designated as a hedging instrument shall
be recognized in P/L.
CASH FLOW HEDGE
 -offsets in whole or in part the variability foreign currency on a specified date in the
in cash flows from a probable forecast future at a specified price or exchange rate
transaction.- uncommitted but -a commitment to purchase or sell a specified
anticipated future transaction. commodity on a future date at a specified
a) Derivative or hedging instrument is price.
measured at FV - a private contract between 2 parties who
b) The change in FV is recognized as know each other very well.
component of OCI to the extent that the Computation:
hedge is effective Market price- Dec 2019 8.5M
c) The ineffective portion is recognized in Underlying price 7.5M
P/L Forward contract receivable 1M
d) The hedged item is not adjusted to
conform with FV. Market-Jan 2020 8.7M
FAIR VALUE HEDGE Underlying price 7.5 M
-offsets in whole or in part the change in Forward contract receivable-Jan2020 1.2M
FV of an asset or a liability. Forward contract receivable-Dec2019 1 M
a) The derivative or hedging instrument is Increase in forward contract receivable 200K
measured at FV
b) Hedged item is also measured at FV in JE:Dec.
contrast with a cash flow hedge where FCR 1M
the hedged item is not adjusted Unrealized gain-forward contract 1M
c) The changes in FV are recognized in P/L Unrealized gain here is a component of OCI
EXAMPLES of Derivative: because the forward contract is designated as
a) Interest rate swap a cash flow hedge
b) Forward contract JAN 2020
c) Future contract FCR 200K
d) Options Unrealized gain-forward contract200K
Cash 1.2M
these derivatives are financial instruments FCR 1.2M
separate from the primary financial Purchase 8.7M
instruments. These would not exist in their Cash 8.7M
own right but have been created solely to Unrealized gain-forward contract1.2M
hedge against financial risks created by other Purchases 1.2M
financial instruments or by transactions that The unrealized gain on forward contract is
have yet to occur but are anticipated. credited directly to purchases
Such can be CR to gain in forward contract
INTEREST SWAP which is an offset to COGS in 2020.
-a contract whereby two parties agree to
exchange cash flows for future interest FUTURE CONTRACT
payments based on a contract of loan. -contract to purchase or sell a specified
commodity on a future date at a specified
Contract of loanprimary financial instrument price.
Interest rate swap derivative financial -main difference with forward contract is
instrument traded in a future exchange market in much
the same manner as debt and equity
FORWARD CONTRACT securities being traded in the stock market
-an agreement between 2 parties to exchange
a specified amount of commodity, security. Or
- a standard contract traded in a futures
exchange market and one party will never
know who is on the other side of the contract.
All cash settlements are made through the
exchange market
OPTION
- A 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.
- Call optionbuyerright to purchase an
asset
- Put optionsellerright to sell an asset
- An option must be paid for, requires
an initial payment for the protection
against unfavorable movement in
price aka option premium
If the market price is lower than the
exercise price, the call option is said to be out
of the money and therefore the call option is
not exercised.
Unlike a forward or future contract, the entity
has no liability if the market price is lower
than the underlying price because call option
requires a small payment for the right to
purchase.
 Call option is a right not an obligation.
Embedded derivative
-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.
-basic contract=host contract
-Interest rate swap, forward contract, futures
contract and option are stand-alone
derivative contracts separate from the
primary contract.
-is not a separate contract.
-both embedded derivative and host contract
are contained in one combined contract.
EXAMPLES:
1. Equity conversion option in a
convertible bond investment that
allows a holder to convert the bond
into shares of the issuer
Convertible bond instrumenthost
contract
Equity conversion featureembedded
derivative
2) Redemption option in an investment in
redeemable preference share that allows the
issuer to repurchase the preference share.
investment in redeemable preferencehost
contract
Redemption option featureembedded
derivative
3) An investment in bond whose interest or
principal payment is linked to the price of gold
or silver
An investment in bondhost contract
Payment of interest or principalembedded
derivative
EMBEDDED DERIVATIVE Accounted for
separately
Bifurcation- process of separating an
embedded derivative from the host contract.
E.D. shall be separated from the host contract
and accounted for as it were a stand-alone
derivative if the following conditions are met:
1) A separate instrument w/ the same terms
as the embedded feature would meet the
definition of a derivative
2) The combined contract is not measured at
FV P/L. Otherwise, THERE IS no need to
separate the embedded feature because the
combined contract is already for similar to
derivative.
3) The economic characteristics and risks of
the embedded feature are not closely related
to the economic characteristics and risks of
the host contract
If separated, the E.D is accounted for at FV
and the host is accounted for in accordance
with PFRS.
Host contract within scope of PFRS 9
-the classification requirements hence of PFRS
9 are applied to the combined contract in its
entirety.
If the host is fin.asset, e.d is not separated.
Depending on the business model of
managing financial asset, the HOST
CONTRACT IN ITS ENTIRETY shall be measured
at:
a) Amortized cost
b) FV P/L
c) FV through OCI