AC3102 Jan2018 Seminar 17 Derivatives 22feb2018

Accounting for Derivatives
Accounting for Derivatives
Learning objectives
1. Derivatives
2. Examples of commonly used derivatives
A Call options and Put options
A.
B. Forward contracts
C Futures
C. F t contract
t t
D. Interest rate swapp
References
• SFRS(I) 9 and IFRS 9
• TLK chapter 10
22 Feb 2018 Lee Kin Wai 1
Derivatives
A derivative is a financial instrument or other contract with all three
characteristics:
(a) its value changes in response to the change in a specified interest
rate, financial instrument price, commodity price, foreign exchange
rate, index of prices or rates, credit rating or credit index, or other
variable, (sometimes called the ‘underlying’);
(b) 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;
(c) it is settled at a future date.
In general, firms transact in derivatives to:

• Manage market risks such as foreign exchange risk and interest rate
risk;
• Reduce borrowing costs;
• Profit from trading or speculation.
speculation
Derivatives
• Fauver and
F d Naranjo
N j (2010) – USA evidence.
id D
Does dderivatives
i ti
increase firm valuation ? What is the role of corporate governance?
• How can derivatives destroy shareholder value? Discuss (i)
Pricewaterhouse Coopers Report on its investigation into the oil
trading losses from China Aviation Oil, 2005 and (ii) Deloitte, The
China Aviation Oil Debacle
Debacle, 2006
2006.
• How do derivatives affect cost of debt (borrowing), capital
expenditure investments and debt covenants? How do we measure
the usage off derivative and extent off hedging by the firm?
f ? Discuss
Campello, Lin, Ma, Zou (2011) The Real and Financial Implications
of Corporate
p Hedging,
g g, (focus
( on page
p g 1615 to p page
g 1624 and p page
g
1642 to page 1644.)
• Lee (2013) – Listed firms in Asia. What are the characteristics of
derivative users vs non-users?
non users? What is the association between
derivatives usage and firm valuation ? Under what conditions, do
derivative usage increase or decrease firm value ?
Examples of commonly used derivatives
1. Call
C options and Put options
2. Forward contracts
3 Futures
3. F t contract
t t
4. Interest rate swap
• Note: For each derivative,
derivative the key issues are:
A. How does the derivative work?
B Payoff diagrams and payoff to buyer versus seller
B. seller.
C. How to estimate the fair value of the derivative? [Note: In the
exam, the fair value of the derivative is usually given to the
students. However, if computation of fair value is required in
the exam, the formulas on the fair value of the derivative and
statistical
t ti ti l tables
t bl willill b
be given.]
i ]
D. The accounting treatment for the derivative.
Options
p
• An option is a contract that gives one party the right, but
not the obligation, to buy or sell a specific amount of an
item ((notional amount)) from / to another pparty
y at a
specific price (strike price or exercise price) in the future
((exercise date).)
• A call option gives the buyer (holder) the right

right, but not
the obligation, to buy a specific amount of an item from
another party at the exercise price on or before maturity
maturity.
• A put
p t option gi
gives
es the bbuyer
er (holder) the right
right, b
butt not
the obligation, to sell a specific amount of an item from
another party at the exercise price on or before maturity.
maturity
Options
Options
• Main features of option contracts
Main features of option contracts
– Purchaser (holder) pays premium to seller (writer of option)
– Buyer (Holder) has the right, but not obligation to perform.
( ld ) h h i h b bli i f
– Seller (Writer) has obligation to perform
– Asymmetrical pay‐off profile
• Holder has limited loss (due to premium) and unlimited gain
• Writer has limited gain and unlimited loss
i h li i d i d li i d l
• There are 2 types of option:‐
• An American option can is exercisable any time between inception
and maturity date.
d i d
• A European option can only be exercised at maturity date.
Relationship between the exercise price (strike
price) and the spot price of underlying item
Strike
St ik price
i Strike
St ik price
i Strike
St ik price
i
> = <
Underlying Underlying Underlying
((spot
p p price)) ((spot
p p price)) ((spot
p p price))
Holder Out-of-the- At-the- In-the-
(buyer) of money money money
p
call option
Holder In-the- At-the- Out-of-the-
(buyer) of money money money
put option
Example 1 – Payoff for call option
Example 1 Payoff for call option
Buy call option on the common share of company A with exercise price of $120 and paid call premium of $10 to the seller of the call.
Underlying share price 80 90 100 110 120 130 140 150 160 170 180
Exercise epriprice 120 120 120 120 120 120 120 120 120 120 120
Call premium paid 10 10 10 10 10 10 10 10 10 10 10
total cost (exercise price + call premium) 130 130 130 130 130 130 130 130 130 130 130
Pay‐off to buyer of call option ‐ Gain/ (loss) ‐10 ‐10 ‐10 ‐10 ‐10 0 10 20 30 40 50
Pay‐off to SELLER of call option ‐ Gain/ (loss 10 10 10 10 10 0 ‐10 ‐20 ‐30 ‐40 ‐50
Example 2 – Payoff for buyer of call option
Pay‐off to buyer of call option ‐ Gain/ (loss)
90
80
70
Gaiin / (loss)
60
50
40
30
Exercise price= 120
20
10
0
80 90 100 110 120 130 140 150 160 170 180 190 200 210
‐10
In the money
out‐of‐money
‐20
Price of underlying
Example 3 – Payoff for seller of call option
Pay‐off to SELLER of call option ‐ Gain/ (loss)
20
10
0
80 90 100 110 120 130 140 150 160 170 180 190 200
10
‐10
out of money
‐20
in the money
ss)
Exercise p
price = 120
Gain/ (los
30
‐30
‐40
‐50
50
G
‐60
‐70
70
‐80
Price of underlying
Valuation of an option contract
• AA widely‐used model to value call option is the Black
id l d d lt l ll ti i th Bl k
and Scholes Option Pricing Model [BSOPM].
• Cost of an option = Option premium = Fair value of
Cost of an option Option premi m Fair al e of
option
• So, for a call option:‐
So for a call option:
Cost of call option
= Option premium paid by buyer of call option to seller of
O i i id b b f ll i ll f
call option
= Option premium received by seller of call option from
O ti i i db ll f ll ti f
buyer of call option
= Fair value of call option to buyer of call option
Fair al e of call option to b er of call option
= Fair value of call option to seller of call option
Black and Scholes Option Pricing Model [BSOPM].

Black and Scholes Option Pricing Model [BSOPM]
Co = SoN(d1) - Xe-rTN(d2)
d1 = [ln(So/X) + (r + s2/2)T] / (s T1/2)
d2 = d1 - (s T1/2)
where
Co = Current call option value
So = Current stock price
N(d) = probability that a random draw from a normal distribution will be
less than d
X = Exercise price
e = 2.71828, the base of the natural log
r = Risk-free interest rate (annualized continuously compounded with the
same maturity
t it as the
th option)
ti )
T = time to maturity (expiration) of the option in years
ln = Natural logg function
s = Standard deviation of the annualized continuously compounded rate of
return of the stock
Black and Scholes Option Pricing Model
Black and Scholes Option Pricing Model
Valuation of call option using Black- Scholes Option Pricing Model
trombley page 32
1) Basic input variables:-
Share price = S 100 101 102 103 104 105 106 107 108 109
Exercise price = X 105 105 105 105 105 105 105 105 105 105
interest rate = R 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05
volatility
y = SIGMA 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3
Time to maturity = T 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25
2) Computation
d1 -0.1669 -0.1006 -0.0349 0.0301 0.0945 0.1583 0.2215 0.2841 0.3461 0.4076
d2 -0.3169
0 3169 -0.2506
0 2506 -0.1849
0 1849 -0.1199
0 1199 -0.0555
0 0555 0 0083
0.0083 0 0715
0.0715 0 1341
0.1341 0 1961
0.1961 0 2576
0.2576
N(d1) 0.4337 0.4599 0.4861 0.5120 0.5377 0.5629 0.5877 0.6118 0.6354 0.6582
N(d2) 0.3756 0.4011 0.4266 0.4523 0.4779 0.5033 0.5285 0.5533 0.5777 0.6016
N( -d1) 0.5663 0.5401 0.5139 0.4880 0.4623 0.4371 0.4123 0.3882 0.3646 0.3418
N( -d2) 0.6244 0.5989 0.5734 0.5477 0.5221 0.4967 0.4715 0.4467 0.4223 0.3984
Present value of exercise price 103.6957 103.6957 103.6957 103.6957 103.6957 103.6957 103.6957 103.6957 103.6957 103.6957
3) Valuation of call options

a) Black & Scholes Value of Call Option 4.4181 4.8650 5.3380 5.8371 6.3619 6.9122 7.4876 8.0874 8.7110 9.3579
b) Intrinsic value of call option = Max (0, S - X) = 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 1.0000 2.0000 3.0000 4.0000
c) Time value of option = Call - intrinsic value 4.4181 4.8650 5.3380 5.8371 6.3619 6.9122 6.4876 6.0874 5.7110 5.3579
4) Valuation of PUT options

a) Value of put option per Black-Scholes Put method (Tombley's p. 32) = 8.1138 7.5606 7.0337 6.5327 6.0576 5.6079 5.1832 4.7830 4.4067 4.0536
b) Value of put option per Put-Call Parity method 8.1138 7.5606 7.0337 6.5327 6.0576 5.6079 5.1832 4.7830 4.4067 4.0536
Example 4 – Valuation of call option
Example 4 Valuation of call option
• Example: Value a call option with these variables:‐
p p
• So = 100
• X = 95
• r = 0.10
• T = 0.25 year (i.e. 3 months)
• s = 0.50 (i.e. 50% per year)
= 0 50 (i e 50% per year)
• Thus:
• Using a table or the NORMDIST function in Excel, we find that
• N (0.43) = 0.6664
• and N
d N (0.18) = 0.5714.
(0 18) 0 5714
• Therefore:
• Co
o = S ) ‐ Xe‐rTN(d2)
SoN(d1)
• Co = 100 * (0.6664) – 95* e‐(0 .10 X .25) * (0.5714 )
• Co = $13.70
Example 5 – Separating the value of call option into (i)
intrinsic value and (ii) time value
• Fair value of option
p = Intrinsic value of option
p + Time value of option
p
Where
• Fair value of option can be measured based on Black and Scholes
Option Pricing Model (or other valuation models such as Binomial
Option Pricing Model).
• Intrinsic value of option = Current share price (S) less exercise price (X)
=S–X
• Time value of option
= Fair value of option less Intrinsic value of option
= Residual value of option due to remaining time from current period to
expiry date
= loss in time value of option due to “time decay”.
• Intrinsic value of a call option

= Max [0, Notional amount (Quantity) x (Spot price of underlying - Exercise price)]
• Intrinsic value of a put option

= Max [[0, Notional amount (Quantity)
( y) x (Exercise
( price
p – Spot
p p price of underlying
y g )]
Example 6 – Separating the value of call option into (i)
intrinsic value and (ii) time value
Separating the value of the call option into (1) intrinsic value and (2) Time value
Underd lying shhare price 200 210 220 230 240 250 260 270 280
E ercisepre price
Exer 230 230 230 230 230 230 230 230 230
Value eofcal
of call optoption 50 50 50 50 50 50 50 50 50
i) Intrinsic vvalalue e=Max(
Max (0 ,,S‐X)
S X ) 0 0 0 0 10 20 30 40 50
i ) time value = Max((0, C ‐ Intrinsic value ) 50 50 50 50 40 30 20 10 0
Example 7 – Valuation of a put option
Example 7 Valuation of a put option
Black and Scholes Method of Put Option valuation #
X -rTT [1-N(d
P = Xe [1 N(d2)] - S0 [1-N(d
[1 N(d1)]
Using Example data:
S = 100, r = 0.10, X = 95, σ =0.5, T = 0.25
We compute:
Value of put option = P = 95e-0.10 x 0.25(1 - 0.5714) - 100 (1 - 0.6664) = $6.35
Another method to value the put option is the “Put-Call Parity”:-

Put = C – S + PV(X)
Put= fair value of put
C = fair value of call option
S = current share price
PV(X) = presentt value
l off exercise
i price
i
Put = C – S + PV(X) = 13.70 – 100 + 92.65 = $6.35
P = C + Xe-rT - So
Using the example data
P = 13.70 + 95 e -0.10 X 0.25 - 100
P = $6.35
$
# See Trombley Chapter 1 page 32 for another numerical illustration of Black and Scholes Option Pricing Model.
Example 8 – Payoff of put option
Buy PUT option on the common share of company A with exercise price of $100 and paid PUT premium of $15 to the seller of the call.
Underlying share price 20 30 40 50 60 70 80 90 100 110 120

Exercise price 100 100 100 100 100 100 100 100 100 100 100
PUTpremi
PUT premiumpai
m paid 15 15 15 15 15 15 15 15 15 15 15
total cost (exercise price + PUT premium) 115 115 115 115 115 115 115 115 115 115 115
Pay‐off to buyer of PUT option ‐ Gain/ (loss) 65 55 45 35 25 15 5 ‐5 ‐15 ‐15 ‐15
Pay‐off to SELLER of PUT option ‐ Gain/ (loss) ‐65 ‐55 ‐45 ‐35 ‐25 ‐15 ‐5 5 15 15 15

Example 9 Payoff to buyer of put option
Example 9 – Payoff to buyer of put option
Pay‐off to buyer of PUT option ‐ Gain/ (loss)
70
60
50
40
Gain / (loss)
30
20
10
Exercise price= 100
in the money out of money
0
20 30 40 50 60 70 80 90 100 110 120 130 140 150
‐10
10
‐20
Price of underlying
Example 10 – Payoff to seller of put option
Example 10 Payoff to seller of put option
PAYOFF DIAGRAM FOR SELLER OF PUT OPTION
Underlying share price 20 30 40 50 60 70 80 90 100 110 120 130
Pay‐off to SELLER of PUT option ‐ Gain/ (loss) ‐65 ‐55 ‐45 ‐35 ‐25 ‐15 ‐5 5 15 15 15 15
Pay‐off to SELLER of PUT option ‐ Gain/ (loss)
20
10
0
20 30 40 50 60 70 80 90 100 110 120 130 140
‐10
10
ain/ (loss)
out of money
in the money
‐20 exercise price
‐30
Ga
‐40
‐50
‐60
60
‐70
Price of underlying
Accounting for call options
• IFRS 9 ‐ Default assumption for derivatives is
that they are trading securities measured at
that they are trading securities measured at
fair value and changes in fair value are
recognized in the profit and loss account.
i di h fi dl
Example 11 – Accounting treatment for call option
(subsequently in‐the‐money)
• Sh
Share price
i off company X iis $66 on 1 S September
t b 20 20x1.
1
Company A buys 1,000 call option on 1,000 common
shares of company X on 1 September 20x1 20x1. Primary
reason for buying the call options is to speculate on the
potential upside
p p g
gain in company
p y X. Call ppremium is $
$7
per unit and exercise price is $68. All call options mature
on 31 May 20x2.
• On 31 December 20x1, share price of company X is $73.
Fair value of the call option is $9 per unit.
• Share price of company X is $83 on 31 January 20x2.
Fair value of the call option is $17 per unit.
• To lock in the gains, Company A closes all call options at
$17 per unit on 31 January 20x2.
Buyer of the call option Seller of the call option
1 September
S t b 20x120 1 1 September
S t b 20x120 1
Dr. Call options (assets) 7,000 Dr. Cash 7,000
Cr Cash
Cr. 7 000
7,000 Cr Call options (liabilities)
Cr. 7 000
7,000
[buys 1,000 call option = 7x 1,000 = 7,000 ] [sell 1,000 call option = 7 x 1,000 = 7,000 ]
31 December 20x1 31 December 20x1
Dr. Call options (assets) 2,000 Dr. Loss on call options (P&L) 2,000
Cr. Gain on call options (P&L) 2,000 Cr. Call options (liabilities) 2,000
[recognize unrealized gain on call options [recognize unrealized loss on call options sold = (
purchased = ( 9 – 7) x 1,000 = 2,000 ] 9 – 7 ) x 1,000 = 2,000 ]
31 January 20x2 31 January 20x2
Dr. Call options (assets) 8,000 Dr. Loss on call options (P&L) 8,000
Cr Gain on call options (P&L) 8,000

Cr. 8 000 Cr Call options (liabilities)
Cr. 8 000
8,000
[recognize unrealized gain on call options [recognize unrealized loss on call options sold =
purchased = (17 - 9) x 1000 = 8,000 ] (17 -9) x 1000 = 8,000 ]
Dr. Cash 17,000 Dr. Call options (liabilities) 17,000
Cr. Call options (assets) 17,000 Cr. Cash 17,000
[close call options purchased]

22 Feb 2018 [close call options sold ]
Lee Kin Wai 23
Example 12– Accounting treatment of call option
(subsequently out ‐ of –money)
• Share price of company Z is $60 $ on 1 September 20x1.
Company B buys 1,000 call option on 1,000 common
shares
h off company Z on 1 S September
t b 20 20x1. 1 PPrimary
i
reason for buying the call options is to speculate on the
potential
t ti l upside
id gain
i iin company Z Z. C
Callll premium
i iis $4
per unit and exercise price is $68. All call options mature
on 31 May 20x2.
20x2
• On 31 December 20x1, share price of company Z is $50.
F i value
Fair l off the
th callll option
ti iis $3 per unit.
it
• Share price of company Z is $20 on 31 January 20x2.
Fair value of the call option is $1
$ per unit.
• Company Z closes all call options at $1 per unit on 31
January 20x2.
Buyer of the call option Seller of the call option
1 September 20x1 1 September 20x1
Dr. Call options (assets) 4,000 Dr. Cash 4,000
Cr. Cash 4,000 Cr. Call options (liabilities) 4,000
[buys 1,000 call option = 4 x 1,000 = 4,000 ] [sell 1,000 call option = 4 x 1,000 = 4,000 ]
31 December 20x1 31 December 20x1
Dr. Loss on call options (P&L) 1,000 Dr. Call options (liabilities) 1,000
Cr. Call options (assets) 1,000 Cr. Gain on call options (P&L) 1,000
[recognize unrealized loss on call options [recognize unrealized gain on call options sold = (
purchased = ( 3 – 4 ) x 1,000
p , = 1,000
, ] 3 – 4 ) x 1,000
, = 5,000
, ]
Dr. Loss on call options (P&L) 2,000 Dr. Call options (liabilities) 2,000
Cr. Call options (assets) 2,000 Cr. Gain on call options (P&L) 2,000
[recognize unrealized loss on call options [recognize unrealized gain on call options sold = (
purchased = ( 1 – 3 ) x 1,000
1 000 = 2,000
2 000 ] 1 – 3 ) x 1,000
1 000 = 2,000
2 000 ]
Dr. Cash 1,000 Dr. Call options (liabilities) 1,000
Cr. Call options (assets) 1,000 Cr. Cash 1,000

[close call options purchased] [close call options sold ]
Example 13 – Accounting treatment of PUT option
Example 13 Accounting treatment of PUT option
• Sh
Share price
i off company X iis $50 on 1 JJanuary
20x1. On 1 January 20x1, Company A buys
1 000 putt option
1,000 ti on 1,000
1 000 common shares
h off
company X. Put option premium is $8 per unit
andd exercise
i price
i iis $
$50.
0 Th
The put options
i
mature on 31 July 20x1.
• On 31 March 20x1, share price of company X is
$40. Fair value of the p
$ put option
p is $
$11 p per unit.
• Share price of company X is $10 on 31 July
20x1 Fair value of the put option is $40 per unit
20x1. unit.
• Put option was closed on 31 July 20x1.
Buyer of the PUT option Seller of the PUT option
Dr. Put options purchased (assets) 8,000 Dr. Cash 8,000
Cr. Cash 8,000 Cr. Put options sold (liabilities) 8,000
[buys 1,000 put option = 8 x 1,000 = 8,000 ] [sell 1,000 put option = 8 x 1,000 = 8,000 ]
31 March 20x1 31 March 20x1
Dr. Put options (assets) 3,000 Dr. Loss on put options (P&L) 3,000
Cr. Gain on put options (P&L) 3,000 Cr. Put options sold (liabilities) 3,000
[recognize unrealized gain on put options purchased [recognize unrealized loss on put options sold
= ( 11 – 8 ) x 1,000 = 3,000 ]
= ( 11 - 8 ) x 1,000 = 3,000 ]
31 July 20x1 31 July 20x1
Dr. Put options (assets) 29,000 Dr. Loss on put options (P&L) 29,000
Cr. Gain on put options (P&L) 29,000 Cr. Put options sold (liabilities ) 29,000
[recognize unrealized gain on put options purchased [recognize unrealized loss on put options sold =
= ( 40 -11)
11) x 1,000 = 29,000 ] ( 40 -11)
11) x 1,000 = 29,000 ]
31 July 20x1 31 July 20x1
Dr. Cash 40,000 Dr. Put options sold (liabilities) 40,000
Cr. Put options purchased (assets) 40,000 Cr. Cash 40,000

[close put options purchased] [close put options sold ]
Forward contract
Forward contract
What is a forward contract?
• A forward contract is an agreement between 2 parties whereby one party
agrees to buy (long position) and the other party agrees to sell (short position)
a specified amount of an item at a fixed price (called forward price or forward
a specified amount of an item at a fixed price (called forward price or forward
rate) for delivery at a specified future date (called maturity date).
• The forward contract is a binding agreement between 2 parties. There is a
contractual obligation on the buyer (seller) to buy (sell) the specified item
from (to) the seller (buyer) at maturity date.
( ) ( y ) y
• Relationship between forward price and spot price:‐
) (t)
Ft = S0 (1 + R )^
(
Where:
Ft = forward price maturing in period t
forward price maturing in period t
S0 = current spot price
R= discount rate
t = number of periods from current period to expiry date of the forward contract.
Valuation of a forward contract
The fair value of a forward contract =
Notional amount x ( Current forward rate - Contracted forward rate)

(1+ r) t
where
Contracted forward rate = forward rate fixed at the
inception of the contract.
Current forward rate = forward rate for the remaining period
to maturity
r = discount rate
t = period to maturity
Valuation of a forward contract
• At inception:-
i ti
1. The fair value of a forward contract is zero. If not,
arbitrage
bit opportunities
t iti arise.
i
2. There is no initial outlay, and neither party has a gain or
a loss at the inception of the contract
contract.
•
• From
F the
th inception
i ti ddatet tto maturity,
t it theth fair
f i value
l off a
forward contract can either be positive (indicating a gain
and an asset) or negative (indicating a loss and a
liability) depending on the relationship between the
current forward rate and the contracted forward rate,, and
whether it is a forward purchase or a forward sale
contract.
Changes in the fair value of a forward contract after inception date
(adapted from TLK Table 10.2 on page 819)
Current forward rate > Current forward rate <
Contracted forward rate Contracted forward rate
Forward · Fair value is positive. · Fair value is negative.

purchase
h · A gain
i iis recorded.
d d · A loss
l iis recorded.
d d
contract · In the balance sheet, the · In the balance sheet, the
forward contract is an asset. forward contract is a liability.
Forward sale · Fair value is negative. · Fair value is positive.

contract · A loss is recorded. · A gain is recorded.
· In the balance sheet
sheet, the · In the balance sheet
sheet, the
forward contract is a liability. forward contract is an asset.
Example 14 ‐ Payoff to buyer of a forward contract
Example 14 Payoff to buyer of a forward contract
Buy USD forward
600
500
400
300
200
profit/ ((loss)
100
0
0.9 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8
‐100
‐200 Forward rate =1.3
‐300
‐400
‐500
spot rate at maturity USD 1 = SGD
Example 15 ‐ Payoff to seller of a forward contract
Example 15 Payoff to seller of a forward contract
SELL USD forward
500
400
300
200
100
profit/ ((loss)
0
0.9 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8
‐100
‐200
‐300 Forward rate =1.3
‐400
‐500
‐600
spot rate at maturity USD 1 = SGD
Accounting for forward contract

Accounting for forward contract
• At inception, no journal entry is needed as

fair value of forward contract is zero
zero.
• During the life of the forward contract,
changes in fair value of forward contract
are recognized in profit and loss account
account.
• At closing g of forward contract or expiration
date, the forward contract can be asset or
liability which entails net settlement
liability, settlement.
Example 16 – Fair value of a forward contract
without discounting
• Company A’s functional currency is S$. On 1 January 20x1, company A
$
entered into a forward contract to buy USD 1,000,000 for delivery on 31
December 20x1. These exchange rates are given:‐
December 20x1. These exchange rates are given:
Example - forward contract without discounting

Notional amount (USD) 1,000,000
interest rate per year 0 current forward rate
contracted forward
SPOT RATE rate 31 Dec forward rate
USD 1 = S$ USD 1 = S$ USD 1 = S$
1-Jan-20x1 1.570 1.620 1.620
31-march-20x1 1.610 1.620 1.730
30-june-20x1 1.770 1.620 1.850
30-sept-20x1 1.880 1.620 1.910
31 d 20 1
31-dec-20x1 2 000
2.000 1 620
1.620 2 000
2.000
Example 16 – Fair value of a forward contract
without discounting
Example - forward contract without discounting
SPOT RATE contracted forward rate 31 Dec forward rate g in forward ratediscount factor Fair value of
Remainder months Change change
g in Fair value
USD 1 = S$ USD 1 = S$ USD 1 = S$ to expiry =(1+(R/12))^T forward contract forward contract
1 Jan 20x1
1-Jan-20x1 1 570
1.570 1 620
1.620 1 620
1.620 12 0 0 0
31-march-20x1 1.610 1.620 1.730 9 0.11 1 110,000 110,000
30-june-20x1 1.770 1.620 1.850 6 0.23 1 230,000 120,000
30-sept-20x1 1.880 1.620 1.910 3 0.29 1 290,000 60,000

31-dec-20x1 2.000 1.620 2.000 0 0.38 1 380,000 90,000
sum total = 380,000
Example 16 – Fair value of a forward contract without discounting
Buyer
y of the forward contract Seller of the forward contract
1 Jan 20x1 1 Jan 20x1

No journal entry is needed. No journal entry is needed.
Fair value of forward contract is nil at inception. Fair value of forward contract is nil at inception.
Dr. Forward contract (asset) S$ 110,000 Dr. Loss on Forward contract (P/L) S$ 110,000
Cr. Gain on forward contract (P/L) S$ 110,000 Cr. Forward contract (liability) S$ 110,000
[change in fair value of forward contract ] [change in fair value of forward contract ]
30 June 20x1 30 June 20x1
30 Sept 20x1 30 Sept 20x1
31 Dec 20x1 31 Dec 20x1
[[change
g in fair value of forward contract ] [[change
g in fair value of forward contract ]
Dr. Cash S$ 380,000 Dr. Forward contract (liability) S$ 380,000
Cr. Forward contract (asset) S$ 380,000
22 Feb 2018 Lee Kin Wai Cr. Cash S$ 380,000 37
[ to close Forward contract ] [ to close Forward contract ]
Example 17 – Fair value of a forward contract with discounting
Example - forward contract with discounting
interest rate per year 0.12 current forward rate
SPOT RATE contracted forward rate 31 Dec forward rate Remainder months Change in forward ratediscount factor Fair value of change in Fair value
USD 1 = S$ USD 1 = S$ USD 1 = S$ to expiry =(1+(R/12))^T forward contract forward contract
1 J 20 1
1-Jan-20x1 1 570
1.570 1 620
1.620 1 620
1.620 12 0 0 0
31-march-20x1 1.610 1.620 1.730 9 0.11 1.093685273 100,577 100,577

30-june-20x1 1.770 1.620 1.850 6 0.23 1.061520151 216,670 116,093
30-sept-20x1 1.880 1.620 1.910 3 0.29 1.030301 281,471 64,801

31-dec-20x1 2.000 1.620 2.000 0 0.38 1 380,000 98,529
sum total = 380,000

,
Example 17 – Fair value of a forward contract with discounting
Buyer of the forward contract Seller of the forward contract
1 Jan 20x1 1 Jan 20x1
No journal entry is needed. No journal entry is needed.
Fair value of forward contract is nil at inception. Fair value of forward contract is nil at inception.
Cr Gain on forward contract (P/L) S$ 100,577
Cr. 100 577 Cr Forward contract (liability) S$ 100,577
Cr. 100 577
30 June 20x1 30 June 20x1
30 Sept 20x1 30 Sept 20x1
Dr. Forward contract (asset) S$ 64,801 Dr. Loss on Forward contract (P/L) S$ 64,801 Cr. Forward
Cr. Gain on forward contract (P/L) S$ 64,801 contract (liability) S$ 64,801
31 Dec 20x1 31 Dec 20x1
Dr.
Dr Forward
For ard contract (asset) S$ 98,529
98 529 Dr.
Dr Loss on Forward
For ard contract (P/L) S$ 98,529
98 529
Dr. Cash S$ 380,000 Dr. Forward contract (liability) S$ 380,000
Cr. Forward contract (asset) S$ 380,000 Cr. Cash S$ 380,000
[ to close Forward contract ] [ to close Forward contract ]
Separate the change in fair value of the forward
contract
• W We can separate t the
th change
h in
i fair
f i value l off th
the
forward contract from inception of the forward
contract
t t into
i t 2 components:- t
((i)) changeg in intrinsic value
= spot rate in current period less spot rate at the
start of the forward contract
(ii) change in time value (residual time value)
= change
h iin ffair
i value
l lless change
h iin iintrinsic
t i i value
l
• This separation
p is useful for usage
g of forward
contract for hedge accounting purposes.
Example 18 – No discounting - Separate the change in fair value of the forward
contract from inception of the forward contract into 2 components: (i) change in
intrinsic value and (ii) change in time value
E l - forward
Example f d contract
t t without
ith t discounting
di ti
Notional amount (USD 1,000,000
SPOT RATE contracted forward 31 Dec forward rate Remainder moChange in forwarddiscount factor Fair value of change in Fair valuechange in spot ratePV expected Cashflow change in PV expected Cashflow change in time value
USD 1 = S$ USD 1 = S$ USD 1 = S$ to expiry =(1+(R/12))^T forward contractforward contract since start based on spot rate based on spot rate
1-Jan-20x1 1.570 1.620 1.620 12 0 0 0 0.000

31-march-20x1 1.610 1.620 1.730 9 0.11 1 110,000 110,000 0.040 40,000 40,000 70,000
3030-jjunene-20x1
20x1 1.770 1.620 1.850 6 0.23 1 230,000 120,000 0.200 200,000 160,000 (40,000)
30-sept-20x1 1.880 1.620 1.910 3 0.29 1 290,000 60,000 0.310 310,000 110,000 (50,000)
31 dec 20x1
31-dec-20x1 2 000
2.000 1 620
1.620 2 000
2.000 0 0 38
0.38 1 380,000
380 000 90 000
90,000 0 430
0.430 430 000
430,000 120 000
120,000 (30 000)
(30,000)
sum total = 380,000 430,000 (50,000)
A=B+C B C
Example 19 – With discounting of time value of money - Separate the change

in fair value of the forward contract from inception of the forward contract into 2
components: (i) change in intrinsic value and (ii) change in time value
E le - forward
Exampl f d contract
t t wiith discountiting
Notional amount ( 1,000,000
interest rate per y 0.12 current forward rate
SPOT RATE contracted forward 31 Dec forward rate Remainder moChange in forwarddiscount factor Fair value of change in Fair valuechange in spot ratePV expected Cashflow change in PV expected Cashflow change in time value
USD 1 = S$ USD 1 = S$ USD 1 = S$ to expiry =(1+(R/12))^T forward contractforward contract since start based on spot rate based on spot rate
1-Jan-20x1 1.570 1.620 1.620 12 0 0 0 0.000

31-march-20x1 1.610 1.620 1.730 9 0.11 1.093685273 100,577 100,577 0.040 36,574 36,574 64,004
3030-jjunene-20x1
20x1 1.770 1.620 1.850 6 0.23 1.061520151 216,670 116,093 0.200 188,409 151,835 (35,742)
30-sept-20x1 1.880 1.620 1.910 3 0.29 1.030301 281,471 64,801 0.310 300,883 112,474 (47,673)
31 dec 20x1
31-dec-20x1 2 000
2.000 1 620
1.620 2 000
2.000 0 0 38
0.38 1 380,000
380 000 98 529
98,529 0 430
0.430 430 000
430,000 129 117
129,117 (30 588)
(30,588)
sum total = 380,000 430,000 (50,000)
A=B+C B C
Futures contract
Futures contract
• What is a futures contract?
What is a futures contract?
• A futures contract is a contract between a buyer or seller and a clearing
house or an exchange such as the Singapore Exchange. The buyer (seller) of
a futures contract has an obligation to take (make) delivery of a specified
quantity of item at a specified price at a specified future date.
Issue Futures contract Forward contract
Flexibility Low – futures contract traded in More flexibility to customize

standard quantity sizes and for to specific needs of parties
designated items only.
g deposit
Margin p based Required.
q Topp up
p marging deposit
p if Not required.
q
on a percentage of losses erode maintenance
the notional amount margin.
of contract
Daily mark to market Yes. No discounting is needed. May not be regularly
marked to market daily.
Di
Discounting
ti may b
be
22 Feb 2018 Lee Kin Wai
needed. 43
Accounting for futures contract

Accounting for futures contract
• At inception, record the initial margin

deposit of futures contract.
contract
• During the life of the futures contract,
changes in fair value of futures contract
are recognized in profit and loss account
account.
• At closing g of futures contract or expiration
date, the futures contract can be asset or
liability which entails net settlement
liability, settlement. Net
margin deposit is also recovered.
Example 20 – futures contract
• On 1 Jan 20x1, company A buys a futures contract on silver at $1,600 per kg. Each futures
contract on silver is 10 kg (i.e. Each futures contract is standardized at 10kg per contract) . The
maturity date is 31 July 20x1. The futures exchange requires 10% of notional amount as margin
deposit. On 20 Feb 20x1, the price of silver increases to $1,700 per kg. On 10 May 20x1, the
price
i off silver
il iincreases tto $2
$2,000
000 per kkg and
d company A closes
l itits position.
iti
1 Jan 20x1
Dr. Margin deposit (asset) 1,600 = 10% x 1,600 x 10
Cr Cash 1,600
Cr. 1 600
[pay margin deposit on silver futures contract]
20 Feb 20x1
Dr. Futures contract (asset) 1,000
Cr. Gain on futures contract [P/L] = (1,700 – 1,600) x 10 = 1,000
[record Gain on futures contract]
10 May 20x1
Dr. Futures contract ((asset)) 3,000
,
Cr. Gain on futures contract [P/L] = (2,000 – 1,700) x 10 = 3,000
[record Gain on futures contract ]
Dr. Cash 5,600

Cr. Futures contract (asset) 4,000
Cr. Margin deposit (asset) 1,600
[to close futures contract and return margin deposit]
Interest rate swap

Interest rate swap
What is an interest rate swap?
What is an interest rate swap?
• Interest rate swap is a contract between 2 counterparties
to exchange interest payments based on a notional
amount (principal amount) and agreed upon interest
rates Although there is no exchange of principal amount
rates. amount,
a notional amount is required to compute the actual cash
flows that are periodically exchanged.
• Reasons for using interest rate swaps:
1 hedge interest rate exposure
1.
2. reduce cost of funding / borrowing
3. to gain by speculating in interest rate movements.
TLK page 873
using Interest rate swap to reduce cost of borrowing.
C
Company Borrow fixed
B fi d rate
t BBorrow floating
fl ti rate
t
(per year) (per year)
A 5% LIBOR + 0.5%
B 7% LIBOR + 1%
Difference 2% 0.5%
Company A has an absolute advantage in both fixed rate and floating rate
borrowings. However, Company A's advantage is greater for fixed rate borrowing
than for floating rate borrowing. Company A has a comparative advantage in fixed
rate borrowing.
borrowing Company B has a comparative advantage in floating rate
borrowing. The difference in the cost of fixed rate borrowing between the two
companies is 2% while the difference in floating rate borrowing is 0.5%. The net
diff
difference iis 1
1.5%.
5% BBoth
th parties
ti can enjoy
j a ttotal
t l savings
i off 1
1.5%
5% if th
they enter
t iinto
t
a swap arrangement. For example, assume that the terms of the swap provide for
Company A paying LIBOR + 0.5% to Company B and receiving a fixed rate at 6%
from Company B, which borrows at LIBOR + 1%.
TLK page 873
using Interest rate swap to reduce cost of borrowing.
A B
1)Originally pay Fixed 5% LIBOR + 1%
2)Under swap: Pays LIBOR + 0.5% Fixed 6%
3) Under swap: Fixed 6% LIBOR + 0.5%

receives
Net result (1) +(2) + (3) Pays LIBOR - 0.5% Pays fixed 6.5%
Gain 1% 0.5%
Example 21 - Interest rate swap to transform
floating rate debt to fixed rate debt
Interest rate swap to transform floating rate debt to fixed rate debt
Original lender X Company A pays fixed rate of 5% to B Company B

original borrower the swap
pays floating rate interest counterparty
(SIBOR) to original lender X
receives floating rate interest (SIBOR) from B
SIBOR in % 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00%
Receive floating rate (%) 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00%
P fifixedd rate
Pay t % -5.00%
5 00% -5.00%
5 00% -5.00%
5 00% -5.00%
5 00% -5.00%
5 00% -5.00%
5 00% -5.00%
5 00% -5.00%
5 00% -5.00%
5 00% -5.00%
5 00%
Net receipt/ (payment) under swap -4.00% -3.00% -2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00%
less pay floating (SIBOR) to lender X -1 00%

-1.00% -2 00%
-2.00% -3 00%
-3.00% -4 00% -5.00%
-4.00% -5 00% -6 00%
-6.00% -7 00%
-7.00% -8 00%
-8.00% -9 00%
-9.00% -10 00%
-10.00%
Effective net receipt/ (payment) -5.00% -5.00% -5.00% -5.00% -5.00% -5.00% -5.00% -5.00% -5.00% -5.00%
Example 22 ‐ Interest rate swap to transform fixed
rate debt to floating rate debt
Interest rate swap to transform fixed rate debt to floating rate debt
Original lender X Company C pays floating (SIBOR) to B Company B

original borrower the swap
pays fixed rate interest counterparty
(say 7%) to original lender X
receives fixed rate interest (7%) from B
SIBOR in
i % 1 00%
1.00% 2 00%
2.00% 3 00%
3.00% 4 00% 5.00%
4.00% 5 00% 6 00%
6.00% 7 00%
7.00% 8 00%
8.00% 9 00%
9.00% 10 00%
10.00%
Receive fixed rate 7% from swap party 7.00% 7.00% 7.00% 7.00% 7.00% 7.00% 7.00% 7.00% 7.00% 7.00%
Pay floating rate (SIBOR) to swap party -1.00%
1 00% -2.00%
2 00% -3.00%
3 00% -4.00%
4 00% -5.00%
5 00% -6.00%
6 00% -7.00%
7 00% -8.00%
8 00% -9.00%
9 00% -10.00%
10 00%
Net receipt/ (payment) under swap 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% -1.00% -2.00% -3.00%
less pay fixed rate 7% to lender X -7.00%

7 00% -7.00%
7 00% -7.00%
7 00% -7.00%
7 00% -7.00%
7 00% -7.00%
7 00% -7.00%
7 00% -7.00%
7 00% -7.00%
7 00% -7.00%
7 00%
Effective net receipt/ (payment) -1.00% -2.00% -3.00% -4.00% -5.00% -6.00% -7.00% -8.00% -9.00% -10.00%
Valuation of interest rate swap
Valuation of interest rate swap
• A
At inception the present value of net difference
i i h l f diff
between fixed rate and floating rate between 2 parties
i
is zero. If fair value is not zero at inception, arbitrage
If f i l i t ti ti bit
opportunities are present.
• We employ the FASB’ s short cut method to value
interest rate swap.
• Under the short cut method, the fair value of an
interest rate swap is determined based on a flat yield
curve (i.e. interest rate is flat from current period to
maturity of swap).
• After inception date, fair value of swap can be positive
or negative due to changes in interest rate.
g g
Example 23 – fair value of interest rate swap

• On 1-1-20x1, A borrows S$ 100,000 6-year floating rate term loan (based on SIBOR) from Bank B.
The interest is paid annually. The principal is repaid on 31-12-20X6.
• On 1-1-20X1,
1 1 20X1, A enters into an interest rate swap with C under which A pays a fixed rate of 3% per
year and receives floating rate SIBOR per year until 31-12-20x6. Assume SIBOR = 2.50% per year.
• Assume hedge accounting does NOT apply. Hence, change in fair value of interest rate swap is
recognized in P&L.
• Fair value of interest rate swap = difference value of floating rate bond and value of fixed rate bond
31-12-20X1
p
Dr. interest expense ((P/L)) 2,500
,
Cr. Cash 2,500
[interest expense on the original floating rate loan with bank B]
Dr. Interest expense (P/L) 500

Cr. Cash 500
[net settlement under the swap = pay 3% and receive SIBOR floating 2.5%]
Dr unrealized loss (P/L) 2

Dr. 2,323
323
Cr. Interest rate swap liability 2,323
At 31-12-20x1, there are 5 remaining years in the interest rate swap.
[fair value loss in the Interest rate swap - see next slide]
Interest rate swap
Fair value of fixed rate debt (coupon = 3 %) at the effective of 2.50%

2 50%
Principal amount $ 100,000
Coupon rate= 3.00%
Term (years) = 5
Discount rate 2.50%
Y
Year 0 1 2 3 4 5 Total
T t l
Cash inflow/ (outflow) based on coupon rate 0 (3,000) (3,000) (3,000) (3,000) (3,000) (15,000)
Principal repayment (100,000) (100,000)
Net cash inflow/ (outflow) 0 (3,000) (3,000) (3,000) (3,000) (103,000) (115,000)
Present value factor 1.0000 0.9756 0.9518 0.9286 0.9060 0.8839
Present value of net cash inflow/ (outlow) 0 (2,927) (2,855) (2,786) (2,718) (91,037) (102,323)
Net present value at effective rate 2.50% (102,323)
Fair value of floating rate bond (cooupon = 2.50 %) at the effective of 2.50 %
Principal amount $ 100,000
Coupon rate= 2.50%
Term (years) = 5
Discount rate 2.50%
Year 0 1 2 3 4 5 Total
Cash inflow/ ((outflow)) based on coupon

p rate 0 ((2,500)
, ) ((2,500)
, ) ((2,500)
, ) ((2,500)
, )
((2,500)
, ) ((12,500)
, )
Principal repayment (100,000) (100,000)
Net cash inflow/ (outflow) 0 (2,500) (2,500) (2,500) (2,500) (102,500) (112,500)
Present value factor 1.0000 0.9756 0.9518 0.9286 0.9060 0.8839
Present value of net cash inflow/ (outlow) 0 (2,439) (2,380) (2,321) (2,265) (90,595) (100,000)
Net present value at effective rate 2.50%
2 50% (100 000)
(100,000)
NPV of fixed rate debt (102,323)

NPV off floating
fl ti ratet debt
d bt (100 000)
(100,000)
Difference = Fair value of interest rate swap (2,323) swap asset / (liability)

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Accounting for Derivatives

In general, firms transact in derivatives to:

Examples of commonly used derivatives

• A call option gives the buyer (holder) the right

Pay‐off to buyer of call option ‐ Gain/ (loss) ‐10 ‐10 ‐10 ‐10 ‐10 0 10 20 30 40 50

Pay‐off to SELLER of call option ‐ Gain/ (loss 10 10 10 10 10 0 ‐10 ‐20 ‐30 ‐40 ‐50

Example 3 – Payoff for seller of call option

Black and Scholes Option Pricing Model [BSOPM].

3) Valuation of call options

4) Valuation of PUT options

• Intrinsic value of a call option

• Intrinsic value of a put option

Another method to value the put option is the “Put-Call Parity”:-

Example 8 – Payoff of put option

Underlying share price 20 30 40 50 60 70 80 90 100 110 120

Pay‐off to SELLER of PUT option ‐ Gain/ (loss) ‐65 ‐55 ‐45 ‐35 ‐25 ‐15 ‐5 5 15 15 15

Dr. Call options (assets) 7,000 Dr. Cash 7,000

Cr Gain on call options (P&L) 8,000

Dr. Cash 17,000 Dr. Call options (liabilities) 17,000

Cr. Call options (assets) 17,000 Cr. Cash 17,000

[close call options purchased]

1 September 20x1 1 September 20x1

Dr. Call options (assets) 4,000 Dr. Cash 4,000

Cr. Cash 4,000 Cr. Call options (liabilities) 4,000

Dr. Cash 1,000 Dr. Call options (liabilities) 1,000

Cr. Call options (assets) 1,000 Cr. Cash 1,000

1 January 20x1 1 January 20x1

Dr. Put options purchased (assets) 8,000 Dr. Cash 8,000

Cr. Cash 8,000 Cr. Put options sold (liabilities) 8,000

Dr. Cash 40,000 Dr. Put options sold (liabilities) 40,000

Cr. Put options purchased (assets) 40,000 Cr. Cash 40,000

Notional amount x ( Current forward rate - Contracted forward rate)

Valuation of a forward contract

Current forward rate > Current forward rate <

Contracted forward rate Contracted forward rate

Forward · Fair value is positive. · Fair value is negative.

Forward sale · Fair value is negative. · Fair value is positive.

Accounting for forward contract

• At inception, no journal entry is needed as

Example - forward contract without discounting

Notional amount (USD) 1,000,000

interest rate per year 0 current forward rate

USD 1 = S$ USD 1 = S$ USD 1 = S$ to expiry =(1+(R/12))^T forward contract forward contract

31-march-20x1 1.610 1.620 1.730 9 0.11 1 110,000 110,000

30-june-20x1 1.770 1.620 1.850 6 0.23 1 230,000 120,000

30-sept-20x1 1.880 1.620 1.910 3 0.29 1 290,000 60,000

1 Jan 20x1 1 Jan 20x1

Example 17 – Fair value of a forward contract with discounting

Example - forward contract with discounting

Notional amount (USD) 1,000,000

interest rate per year 0.12 current forward rate

USD 1 = S$ USD 1 = S$ USD 1 = S$ to expiry =(1+(R/12))^T forward contract forward contract

31-march-20x1 1.610 1.620 1.730 9 0.11 1.093685273 100,577 100,577

30-sept-20x1 1.880 1.620 1.910 3 0.29 1.030301 281,471 64,801

sum total = 380,000

interest rate per year 0 current forward rate

1-Jan-20x1 1.570 1.620 1.620 12 0 0 0 0.000

Example 19 – With discounting of time value of money - Separate the change