FORWARDS,

FUTURES, OPTION,
FOREIGN
CURRENCY
DERIVATIVES
FORWARD CONTRACT

• An agreement between two parties to exchange a specified amount

of commodity, security or foreign currency on a specified date in
the future at a specified price or exchange rate
• Simply, a commitment to purchase or sell a specified commodity
on a future date at a specified price
• One of the parties to a forward contract assumes a long position
and agrees to buy the underlying asset on a certain specified future
date for a certain specified price.
• The other party assumes a short position and agrees to sell the asset
on the same date for the same price.
FORWARD CONTRACT
TERMS

• Long position - Buyer

• Short position - Seller

• Spot price – Price of the asset in the spot market.(market price)

• Delivery/forward price – Price of the asset at the delivery date.

 FORWARD CONTRACT
RISKS IN FORWARDS

OPERATIONAL
CREDIT RISK LIQUIDITY RISK
RISK
Will the other party
make delivery? Will the In case either party
Does the other party other party accept wants to opt out of the
have the means to pay? delivery? contract, how to find
another counter party?
 FORWARD CONTRACT
EXAMPLE

Assume Alice and Bob enter into a Forward

contract where they agree to exchange 1 Bitcoin at
the current price of $10,000 three months from
now. Bob is the seller and thus has a short
position, while Alice the buyer and therefore has
a long position. If the actual price of Bitcoin rises
to $11,000 by the end of the contract, it would
mean a loss of $1,000 to Bob. Bob has to deliver 1
Bitcoin, which he has to buy for $11,000, for
which he’ll only receive the agreed price of
$10,000. On the other hand, Alice will have a
profit of $1,000. She gets 1 Bitcoin for the agreed
price of $10,000, while it is worth $11,000. This is
the final outcome for both the Forward and
Futures contract at the expiry date.
 FORWARD CONTRACT
ACCOUNTING
Illustration : On January 1, 2019, Gentle Company expects to purchase Market price - Dec. 31, 2019 (50,000 x P1700 8,500,000
50,000 kilos of tobacco from a supplier on January 31, 2020 at the Underlying price (50,000 x P150) 7,500,000
prevailing market price on such date. Forward Contract Receivable - Dec. 31, 2019 1,000,000
2019
Recent market factors indicate that the market price of tobacco per kilo Dec 31 Forwad Contract Receivable 1,000,000
is within the vicinity of P150. Unrealized Gain - Forward Contract 1,000,000

To protect itself from the variability of the market price of tobacco, Market Price - Jan. 31, 2020 (50,000 x P175) 8,750,000
Gentle Company entered into a forward contract with a speculator Underlying price (50,000 x P150) 7,500,000
bank under the following terms: Forward Contract Receivable - Jan. 31, 2020 1,250,000
Forward Contract Receivable - Dec. 31, 2019 1,000,000
a. If the market price is more than P150,000, the excess is paid by Increase in forward contract receivable 250,000
the bank to Gentle Company 2020
Jan-31 Forward Contract Receivable 250,000
b. If the market price is less than P150, the deficiency is paid by Unrealized Gain - Forward Contract 250,000
Gentle Company to the bank.
31 Cash 1,250,000
Forward Contract Receivable 1,250,000
This contract is designated as a cash flow hedge.
31 Purchases (50,000 x P175) 8,750,000
Market price of tobacco per kilo Cash 8,750,000

31 Unrealized Gain - Forward contract 1,250,000

December 31, 2019 - P170 December 31, 2020- P175
Purchases 1,250,000
FUTURES CONTRACT

• Is a contract to purchase or sell a specified commodity at some

future date at a specified price
• The main difference with a forward contract is that the futures
contract is traded in a futures exchange market in much the same
manner as debt and equity securities being traded in the stock
market.
• 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.
 FUTURES CONTRACT
EXAMPLE

The key difference between Futures and

Forwards is in the fact that Futures are
settled on a daily basis and Forwards are
not. If prices move to $11,000 per Bitcoin
the next day, then the gains and losses
would be immediately credited or
deducted. This is why margin
requirements apply for Futures trading.
For Forwards, nothing happens until
maturity. Therefore, the intermediate
gains and losses can never be greater
than the final value.
 FUTURES CONTRACT
ACCOUNTING
Market price - Dec. 31, 2019 (50,000 x P60) 3,000,000
Durable Company produces bottled apple juice. Apple juice
Underlying price (50,000 x P50) 2,500,000
concentrate is typically purchased and sold by the kilo. Futures Contract Receivable - Dec. 31, 2019 500,000
2019
The entity uses 50,000 kilos of apple juice concentrate each month.
Dec 31 Futures Contract Receivable 500,000
Unrealized Gain -Futures Contract 500,000
On December 1, 2019, the entity entered into an apple juice concentrate
futures contract to purchase 50,000 kilos of concentrate on February 1, Market Price -Feb 1 2019 (50,000 x P52) 2,600,000
2020 at a fixed price of P50 per kilo or P2,500,000. Underlying price 2,500,000
Forward Contract Receivable - Feb. 1, 2020 100,000
The contract means that if the price of apple juice is more than P50 on Forward Contract Receivable - Dec. 31, 2019 500,000
Feb. 1, 2020, Durable Company will receive a cash payment from the Increase in forward contract receivable - 400,000
speculator equal to the difference. 2020
Feb-01 Purchases 2,600,000
If the price is less than P50 on February 1, 2020, Durable Company will Cash (50,000 x 52) 2,600,000
make cash payment to the speculator for the difference.
1 Unrealized gain - future contract 400,000
The futures contract is designated as a cash flow hedge. Futures Contract Receivable 400,000

Market price of the apple juice concentrate 1 Cash 100,000

Futures contract receivable 100,000
December 31, 2019 P60 February 1, 2020 P52
1 Unrealized Gain - Futures contract 100,000
Purchases 100,000
OPTIONS

• 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.
• An option is a right and NOT an obligation to purchase or sell
• Call option on the part of the buyer, and gives the holder the right to
purchase an asset.
• Put Option on the part of the seller, and gives the holder the right to sell
and asset.
• An option must be paid for
• Requires an initial small payment for the protection against unfavorable
movement in price. Payment is commonly know as the “option
premium”.
OPTIONS
FEATURES OF OPTIONS

• A fixed maturity date on which they expire (Expiry date)

• The price at which the option is exercised is called the exercise price
or strike price
• The person who writes the option and is the seller is referred as the
“option writer”, and who holds the option and is the buyer is called
the “option holder”
• The premium is the price paid for the option by the buyer to the
seller.
• A clearing house is interposed between the writer and the buyer
which guarantees performance of the contract.
OPTIONS
TERMS

• Underlying: Specific security or asset.

• Option premium: Price paid.
• Strike price: Pre-decided price.
• Expiration date: Date on which option expires.
• Exercise date: Option is exercised.
• Open interest: Total numbers of option contracts that have not yet
been expired.
OPTIONS
TERMS

• Option holder: One who buys option.

• Option writer: One who sells option.
• Option class: All listed options of a type on a particular instrument.
• Option series: A series that consists of all the options of a given
class with the same expiry date and strike price.
• Put-call ratio: The ratio of puts to the calls traded in the market.
CALL OPTION

Fair value of call option (100,000 x P2) 200,000

On December 31, 2019, Stable Company projects a need for 100,000 Payment for call option 50,000
units of a raw material to be purchased at the middle of 2020. Increase in Fair value 150,000

The raw material is selling at P50 per unit on December 1, 2019. The 2019
entity is concerned with the movement of prices of the raw material Dec-01 Call Option 50,000
between Dec. 1, 2019 and July 1, 2020. Cash 50,000

As a protection against the increase in price of the raw material, the Dec-31 Call Option 150,000
Unrealized Gain - call option 150,000
entity entered into a call option contract with financial speculator by
Fair value of call option on July 1, 2020
paying P50,000 for the option on Dec. 1, 2019. (100,000 x P5) 500,000
Call Option - Dec. 31, 2020 200,000
The call option gives the entity the right but not the obligation to Increase in Fair value 300,000
purchase 100,000 units of the raw material at P50 per unit. 2020

Jul-01 Call Option 300,000

The call option contract is the derivative financial instrument that is Unrealized Gain - call option 300,000
designated as a cash flow hedge.
1 Cash 500,000
Call Option 500,000
Market price of the raw material
1 Raw materials purchases) 5,500,000
Dec. 31, 2019 P52 July 1, 2020 P55 Cash (`00,000 x P55) 5,500,000

1 Unrealized Gain - Call Option 450,000

Purchases 450,000
CALL OPTION

Fair value of call option (100,000 x P2) 200,000

On December 31, 2019, Stable Company projects a need for 100,000 Payment for call option 50,000
units of a raw material to be purchased at the middle of 2020. Increase in Fair value 150,000

The raw material is selling at P50 per unit on December 1, 2019. The 2019
entity is concerned with the movement of prices of the raw material Dec-01 Call Option 50,000
between Dec. 1, 2019 and July 1, 2020. Cash 50,000

As a protection against the increase in price of the raw material, the Dec-31 Call Option 150,000
Unrealized Gain - call option 150,000
entity entered into a call option contract with financial speculator by
paying P50,000 for the option on Dec. 1, 2019.

The call option gives the entity the right but not the obligation to 2020
purchase 100,000 units of the raw material at P50 per unit. Jul-01 Raw materials purchases) 4,500,000
Cash (100,000 x P45) 4,500,000
The call option contract is the derivative financial instrument that is
designated as a cash flow hedge. 1 Loss on Call Option 50,000
Unrealized Gain - Call Option 150,000
Market price of the raw material Call Option 200,000

Dec. 31, 2019 P52 July 1, 2020 P45

OPTIONS
“MONEYNESS”

MONEYNESS : Concept that refers to the potential profit or loss

from the exercise of the option. An option maybe in the money, out of
the money, or at the money.
Call Option Put Option
In the money Spot Price > Strike Price Spot Price < Strike Price

At the Money Spot Price =Strike Price Spot Price =Strike Price

Out of the Money Spot Price < Strike Price Spot Price > Strike Price
FOREIGN CURRENCY FORWARD CONTRACT

• When foreign loans or obligations must be repaid in foreign

currency, a foreign currency risk always arises by reason of the
volatility of the exchange rate of the peso in relation to the foreign
currency
• As a protection against this foreign currency risk, the entity enters
into a contract with a bank or any financial institution to the effect
that if the exchange rate of the peso increases, the bank shall pay
the entity for the difference in the exchange rate.
• A forward exchange contract is an agreement between two parties
to exchange two designated currencies at a specific time in the
future.
 FOREIGN CURRENCY FORWARD CONTRACT

An entity has the Philippine peso as the functional currency. 2020

On October 1, 2020, the entity expects to purchase an Oct-01 No journal entry required
equipment from USA for $10,000 on March 31, 2021. (Forward contract has a fair value of zero on this date)
Dec. 31, 2020 ($10,000 x P45) 450,000
Accordingly, the entity is exposed to a foreign currency
Oct. 1 2020 ($10,000 x P43) 430,000
exchange risk.
Increase in exchange rate 20,000
Dec-31 Forward Contract Receivable 20,000
If the dollar increases before the purchase takes place, the
Unrealized Gain - Forward Contract 20,000
entity will have to pay more pesos to obtain the $10,000 that it 2021
will have to pay for the equipment. Mar-31 Forward Contract Receivable 10,000
Unrealized Gain - Forward Contract 10,000
To offset the risk of increases in the dollar rate, the entity
Mar-31 Cash 30,000
entered into a forward currency contract on October 1, 2020 to
Forward Contract Receivable 30,000
purchase $10,000 in six months for a fixed amount of P430,000
or P43 to $1. Mar-31 Equipmemt 460,000
Cash 460,000
This forward currency contract is the derivative financial
Mar-31 Unrealized Gain - Forward Contract 30,000
instrument that is designated as cash flow hedge.
Equipment 30,000
March 31, 2021 ($10,000 x P46) 460,000
On December 31, 2020, the exchange rate is P45 to $1 and on Underlying price ($10,000 x P43) 430,000
March 31, 2016, the exchange rate is P46 to $1. Forward contract receivable - March 31, 2021 30,000
Forward contract receivable - Dec. 31, 2020 20,000
Increase in forward contract receivable 10,000
FAIR VALUE HEDGE

Fair value hedges are designated to hedge the exposure to potential

changes in the fair value of:
a) a recognized asset or liability such as available-for-sale investments
or
b) an unrecognized firm commitment for which a binding agreement
exists
• The net gains and losses on the hedged asset or liability and the
hedging instrument are recognized in current earnings on the
statement of income
 FOREIGN CURRENCY FORWARD CONTRACT

Cash Settlement computation:

On October 1, 2015, an entity purchased an equipment from USA for December 31, 2015 ($100,000 x P45) 4,500,000
$100,000. This contract is the primary financial instrument. October 1, 2015 ($100,000 x P43) 4,300,000
Cash Settlement 200,000
On this date, the peso exchange rate to the dollar is P43 and therefore the
peso equivalent is P4,300,000. 2015
Oct-01 Equipment 4,300,000
The purchase is payable on January 31, 2016 and denominated in dollars, Accounts Payable 4,300,000
meaning, the entity must pay $100,000 regardless of the peso equivalent. #

To protect itself from the foreign currency risk, the entity entered into a Dec-31 Loss on Foreign Exchange 200,000
foreign currency forward contract with a large bank under the following terms:
Accounts Payable 200,000
a. If the exchange rate is more than P43, the bank shall pay the entity
(Remeasurement of the foreign currency payable on Dec 31, 2015)
for the difference.
Dec-31 Forward Contract Receivable 200,000
b. If the exchange rate is less than P43, the entity shall pay the bank for Gain on Forward Contract 200,000
the difference.
2016 200,000
This foreign currency forward contract is the derivative financial instrument Jan-31 Cash
and designated as a fair value hedge of the value of the payable that is Forward Contract Receivable 200,000
denominated in foreign currency.
#
Jan-31 Accounts Payable 4,500,000
The exchange rate is P45 on December 31, 2015.
Cash 4,500,000
EMBEDDED DERIVATIVE
EMBEDDED DERIVATIVE

• An embedded derivative is 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.
• This simply means that there is a basic contract known as the “host
contract” that has an embedded derivative.
• An embedded derivative is not a separate contract. Both the
embedded derivative and the host contract are contained in one
combined contract.
 EMBEDDED DERIVATIVE
EXAMPLES

✓ Equity conversion option in a convertible bond instrument that allows the holder
to convert the bond into shares of the issuer. The convertible bond instrument is
the host contract and the equity conversion feature is the embedded derivative.

✓ Redemption option in an investment in redeemable preference share that allows

the issuer to repurchase the preference share. The investment in redeemable
preference share is the host contract and the redemption option feature is the
embedded derivative.

✓ An investment in bond whose interest or principal payment is linked to the price

of gold or silver. The investment is bond is the host contract and the embedded
derivative is the payment of interest or principal based on the price of gold or
silver.

The embedded derivative is a commodity derivative.

THANK YOU!