Derivatives

Flashcards about Derivatives and Hedging

Derivative

• A financial instrument that derives its value from the movement in commodity prices, foreign exchange rate, and interest rate of an underlying asset or financial instrument.

• It is an executory contract, not a transaction, because it is an exchange of promises about future action.

• They are used for hedging. They are also called hedging instruments.

• It created rights and obligations that have the effect of transferring between the parties to the instrument the financial risks inherent in an underlying primary financial instrument.

Price risk

Uncertainty in the future price of an asset.

Credit risk

Uncertainty over whether a counterparty or the party on the other side of the contract will honor the terms of the contract.

Interest rate risk

Uncertainty about future interest rates and their impact on cash flows and the fair value of financial instruments.

Foreign exchange risk

Uncertainty about future Philippine peso cash flows stemming from assets and liabilities denominated in foreign currency.

Underlying variable

A specified interest rate, commodity price, foreign exchange rate, index of prices or rates, and other variables that influence the value of a derivative. It may be a price or rate of an asset or a liability but not the assets or liability itself.

Forward contract

A contract to purchase or sell a commodity at a designated future date at a predetermined price; a private or over-the-counter contract between two parties. Banks are the typical counterparties.

Futures contract

A contract to purchase or sell a commodity at a designated future date at a predetermined price; a standardized contract traded on an 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 (not an obligation) to purchase or sell an asset at a specified price within a given future time period. A derivative that requires initial small payment for the protection against unfavorable movement in price. Thus, it must be paid for unlike an interest rate swap, forward contract and future contract.

Call option

Gives the holder the right to purchase an asset.

Put option

Gives the holder the right to sell an asset.

Interest rate swap (IRS)

A contract whereby two parties agree to exchange cash flows for future interest payments based on a contract of loan.

Hedging

Designating one or more hedging instruments so that their change in fair value is an offset, in whole or in part, to the change in fair value or cash flows of a hedged item. A means of protecting a financing loss or the structuring of transactions to reduce risk.

Fair value hedge

Protection against the risk from changes in fair value caused by fixed terms, rates, or prices.

Cash flow hedge

Protection against the risk from changes in cash flows caused by variable terms, rates, or prices.

Hedge of a net investment in a foreign operation

Involves an underlying variable which is the foreign currency.

Four types of Financial risks

• Price risk

• Credit risk

• Interest rate risk

• Foreign exchange risk

Basic types of derivatives

• Forward contract

• Future contract

• Option

• Interest rate swap

Hedged items can be

• A single asset or liability

• Firm commitment

• Highlt probable forecast transaction

• Net investment in a foreign operation

Three types of relationship in hedging

• Fair value hedge

• Cash flow hedge

• Hedge of a net investment in a foreign operation

Hedge Accounting

• All derivatives are recognized as either “investment” assets or liabilities being recognized by either party, as market conditions change.

• They are measured at fair values. A change in fair values requires the recognition of a gain or loss. A gain or loss on derivative financial instruments is accounted for depending on how the derivative is used.

Accounting in a gain or loss on derivative financial instruments when the derivative is used without hedging designation

Changes in fair value are recognized in earnings immediately.

Accounting in a gain or loss on derivative financial instruments when the derivative is used in Fair value hedge

Changes in fair value are recognized in earnings immediately. Gain or loss on the hedged risk should adjust the carrying amount of the hedged items and be recognized in earnings immediately.

Accounting in a gain or loss on derivative financial instruments when the derivative is used in Cash flow hedge

The effective portion of the gain or loss on the hedging instrument is reported in equity. The ineffective portion of the gain or loss on the hedging instrument is reported immediately in earnings.

Accounting in a gain or loss on derivative financial instruments when the derivative is used in Hedge of a net investment in foreign operation

The effective portion of the gain or loss on the hedging instrument is reported in equity. The ineffective portion of the gain or loss on the hedging instrument is reported immediately in earnings.

Types of Option

Call option and Put option