Derivatives

By: Dr. Angeles A. De Guzman

Dean, College of Business Education
 Derivatives
• Derivatives are becoming increasingly common
but very complicated
• Huge losses may be suffered by banks and
other financial institutions because of too much
exposure in derivative financial instruments
• Trading in derivatives has been likened to a wild
frontier where adventure and danger are
constant companion.
 Purpose of Derivatives
• Entities use derivatives financial instruments to manage
financial risk. Financial risk originates from sources, such
as change in commodity price, change in cash flows and
foreign currency exposure.
• The reduction of financial loss stemming from the financial
risk is the motivating factor in trading in derivatives
• Derivative financial instruments create 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.
 Types of financial Risks
• Price risk is the uncertainty about the future price of an
asset
• Credit risk is the 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 is the uncertainty about future interest
rates and their impact on cash flows and the fair value of
the financial instruments
• Foreign currency risk is the uncertainty about future
Philippine peso cash flows stemming from assets and
liabilities denominated in foreign currency
 What is a Derivative
• A derivative is simply a financial instrument that derives its value
from the movement in commodity price, foreign exchange rate and
interest rate of an underlying asset or financial instrument
• It is an executory contract, meaning it is not a transaction but an
exchange of promises about future action.
• On inception, derivative financial instruments give one party a
contractual right to exchange financial asset or financial liability with
another party under conditions that are potentially favorable, while
the other party has a contractual obligation to exchange under
potentially unfavorable conditions.
• Parties to the derivative financial instrument are taking bets on what
will happen on the underlying financial instrument in the future
 Characteristics of a derivative
• The value of the derivative changes in
response to the change in an underlying
variable
• The derivatives requires either no initial net
investment or an initial net investment
• The derivative is readily settled at a future
date by a net cash payment
 Hedging
• It means designating one or more hedging
instruments so that the change in fair value or cash
flows is an offset, in whole or in part, to the change
in fair value or cash flows of a hedged item.
• It is a means of protecting a financial loss or the
structuring of a transaction to reduce risk
• Three types of hedging relationship are fiar value
hedge, cash flow hedge, hedge of a net investment
in a foreign operation
Components of a Hedging Relationship

• Hedging instrument is the derivative whose

fair value or cash flows would be expected to
offset changes in the fair value or cash flows of
the hedged item
• Hedged item is an asset, liability, firm
commitment, highly probable forecast
transaction or net investment in a foreign
operation
 Measurement of Derivatives
• An entity shall recognize and measure all derivatives as
either assets or liabilities at fair value
• Both fair value and notional shall be fully disclosed. A gain
or loss is recognized when there is change in the fair value
• Whether the change in fair value is recognized in profit or
loss or in other comprehensive income depends on the
following situations
– The derivative is not designated as a hedging instrument
– The derivative is designated as a cash flow hedge
– The derivative is designated as a fair value hadge
 No Hedging Designation
• Changes in fair value of a derivative that is not
designated as a hedging instrument shall be
recognized in profit or loss
• The derivative can be thought of as a
speculation
 Cash Flow Hedge
• A cash flow hedge is a derivative that offsets in whole or
in part the variability in cash flows from a probable
forecast transaction
• A probable forecast transaction is an uncommitted but
anticipated future transaction
– The derivative or hedging instrument is measured at fair value
– The change in fair value is recognized as component of other
comprehensive income to the extent that the hedge is
effective
– The ineffective portion is recognized in profit or loss
– The hedged item is not adjusted to conform with fair value
 Fair Value Hedge
• A fair value hedge is a derivative that offsets in
whole or in part the change in the fair value of an
asset or a liability
– The derivative or hedging instrument is measured at
fair value
– The hedged item is also measured at fair value in
contrast with a cash flow hedge where the hedged
item is not adjusted
– The changes in fair value are recognized in profit or
loss
 Examples of Derivatives
• Interest rate swap
• Forward contract
• Futures contract
• Option
• Foreign currency forward contract
 Interest rate Swap
• Is a contract whereby two parties agree to
exchange cash flows for future interest
payments based on a contract of loan
• The contract of loan is the primary financial
instrument and the interest rate swap
agreement is the derivative financial
instrument
 Forward Contract
• A forward contract is a commitment to
purchase or sell a specified commodity on a
future date at a specified price
 Future Contract
• Is a contract to purchase or sell a specified commodity
at some future date at a specified price.
• Future contract is traded in a futures exchange market
in much the same manner as debt and equity
securities being traded in stock market
• Forward contract is a private contract between two
parties who know each other very well. A futures
contract is a standard contract traded in a futures
exchange market and one party will never know who
is on the other side of the contract
 Option
• An option is 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
• A call option gives the holder the right to
purchase an asset, and put option gives the
holder the right to sell an asset
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 proves unfavorable to the entity because the
exchange rate of the peso increases, the bank shall
pay the entity for the difference in the exchange rate
 Embedded Derivative
• It is a component of a hybrid or combined contract
that also includes a nonderivative host contract
with the effect that some of the cash flows of the
combined contract vary in a way similar to a stand
alone derivative
• When a derivative feature is embedded in a
nonderivative contract, the derivative is called as an
embedded derivative and the contract into which it
is embedded is referred to as a host contract
 Bifurcation
• It is the process of separating an embedded derivative
from the host contract on the following conditions
– A separate instrument with the same terms as the
embedded feature would meet the definition of a derivative
– The combined contract is not measured at fair value through
profit or loss
– The economic characteristics and risks of the embedded
feature are not closely related to the economic
characteristics and risks of the host contract
– The host contract is outside the scope of PFRS 9
Examples of Embedded Derivatives
• Equity conversion option in a convertible bond
instrument that allows the holder to convert
the bond into shares of the issuer
• Redemption option in an investment in
redeemable preference share that allows the
issuer the repurchase the preference share
• An investment in bond whose interest or
principal payment is linked to the price of gold
or silver