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Derivatives and Hedging PDF

The document discusses derivatives and hedging. It defines derivatives as financial instruments whose value depends on an underlying asset or rate. Common underlyings include stock prices, interest rates, exchange rates, and commodity prices. Derivatives are used for speculation by recording fair value changes in profit/loss, and for hedging to manage risk. Basic derivative types for hedging are forward contracts, futures contracts, options, and swaps. Hedging items include firm commitments, probable future transactions, and converting fixed to floating or floating to fixed interest rates. Fair value hedges record changes in profit/loss, while cash flow hedges record changes in other comprehensive income. Three problems demonstrate calculations for foreign exchange forward contracts

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Krizia Mae Flores
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2K views4 pages

Derivatives and Hedging PDF

The document discusses derivatives and hedging. It defines derivatives as financial instruments whose value depends on an underlying asset or rate. Common underlyings include stock prices, interest rates, exchange rates, and commodity prices. Derivatives are used for speculation by recording fair value changes in profit/loss, and for hedging to manage risk. Basic derivative types for hedging are forward contracts, futures contracts, options, and swaps. Hedging items include firm commitments, probable future transactions, and converting fixed to floating or floating to fixed interest rates. Fair value hedges record changes in profit/loss, while cash flow hedges record changes in other comprehensive income. Three problems demonstrate calculations for foreign exchange forward contracts

Uploaded by

Krizia Mae Flores
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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DERIVATIVES AND HEDGING

DERIVATIVES – are financial instruments whose value depends on the value of an


underlying.

EXAMPLES OF UNDERLYING:
• Stock price
• Interest rate
• Exchange rate
• Commodity price

USES OF DERIVATIVES
• Speculation – record at fair value thru profit and loss
– charge mark to market changes to profit and loss
• Hedging – managing risk

BASIC TYPES OF DERIVATIVES (HEDGING INSTRUMENTS)


a. Forward Contracts – are derivatives, are commitment to buy or sell something
in the future.
– private transactions or over the counter
b. Futures Contracts – same as forward contracts both commitments to buy or
sellsomething in the future.
– traded in an exchange.
c. Options – choice or right to execute contract.
– disadvantage: paying premium
• Call Option – option to buy.
• Put Option - option to sell.
d. Swaps – interest rate swap
• Fixed to Floating – fixed rate loan converted to floating rate loan.
• Floating to Fixed – floating rate loan converted to fixed rate loan.

HEDGING ITEMS Fair value Cash Flow


1. Firm Commitment
– committed to buy or sell something in the future ✓
– future transaction with fixed price.
2. Highly Probable Future Transaction
– expecting transaction, cash flow is unknown. ✓
3. Fixed to Floating Rate ✓
4. Floating to Fixed Rate ✓

Fair Value Hedge – hedging changes in fair value.


– amount is known.
Cash Flow Hedge – hedging variability in cash flow.
– amount is unknown
Fair value Cash Flow
Hedging Instruments Mark to market charged Mark to market charged
to profit or loss. to other comprehensive
income.
Hedge Items Mark to market charged Normal accounting
to profit or loss.
NOTES:
➢ If hedging instrument is gain, hedge items is at loss, and vice-versa.
➢ Purpose of hedge accounting is to prevent fluctuations in profit or loss.

NOTES IN COMPUTING: To avoid confusion in gain(loss).

➢ In computing hedged item:


• SELLER: Future Date – Previous Date
(December – November)
• BUYER: Previous Date – Future Date
(November – December)
Use spot date in hedged item.
➢ In computing hedging instrument previous date comes first.
• SELLER: Previous Date – Future Date
(November – December)
• BUYER: Future Date – Previous Date
(December – November)

PROBLEM 1:
The following data apply to Confidence Company’s purchases of 45,400 Belgium francs
under a forward contract dated November 2, 2019, for delivery on January 31, 2020:
11/2/19 12/31/20 01/31/20
Spot rates P 55.75 P 53.90 P 54.50
30-day forward rate P 51.30 P 56.15 P 53.20
60-day forward rate P 57.65 P 52.30 P 55.75
90-day forward rate P 54.25 P 55.45 P 52.10

Confidence entered into the following contract to speculate in the foreign currency.

Questions:
a. In its income statement for the year-end 2019, what amount of gain/loss should
Confidence report from this forward contract?

Fair value, December 31,2019 (F45,400 x P56.15) P 2,549,210


Fair value, November 2, 2019 (F45,400 x P54.25) (2,462,950)
Gain on Forward Contract P 86,260
b. In its income statement for the year-end 2020, what amount of gain should
Confidence report from this forward contract?

Fair value, January 31, 2020 (F45,400 x P54.50) P 2,462,950


Fair value, December 31,2019 (F45,400 x P56.15) (2,549,210)
Loss on Forward Contract (P 74,910)

PROBLEM 2:
Prayer Company sold merchandise for 111,200 euros to a customer in France on
November 2, 2019. Collection in euros was due on January 31, 2020. On the same date,
to hedge this foreign currency exposure, Prayer Company entered into a future
contract to sell 111,200 euros to Metrobank for delivery on January 31, 2020. Exchange
rates for euros on different date are as follows:
Nov. 2 Dec. 31 Jan.31
Spot rate 81.9 80.7 80.1
30-day futures 82.3 80.4 83.9
60-day futures 81.8 80.3 82.6
90-day futures 80.6 81.6 83.4
120-day futures 80.1 81.4 82.8
Questions:

a. What amount will affect profit or loss regarding the hedged item on the financial
statement date in 2019?

Accounts receivable €111,200


Multiply: (P80.7 – 81.9) (P 1.2)
Forex Loss (P 133,440)

b. What amount will affect profit or loss regarding the hedged instrument on the
settlement date in 2020?

Fair value, December 31,2019 (€111,200 x P80.4) P 8,940,480


Fair value, January 31, 2020 (€111,200 x P80.1) (8,907,120)
Gain on Future Contract P 33,360

c. As a result of all foregoing transactions, what amount will affect current earnings
on the settlement date in 2020?

Hedging Instrument P 33,360


Hedged Item [€111,200 x (80.1 – 80.7)] (66,720)
Loss (P 33,360)
PROBLEM 3:

On October 5, 2019, CPA Title Philippines took delivery from Thailand firm of inventory
costing 1,140,00 baht. Payment is due on January 30, 2020. Concurrently, CPA Title
Philippines paid P15,700 cash to acquire an at-the-money call option for 1,140,000 baht.
Strike price is P12.40.
10/5/19 12/31/19 1/30/20
Market price P 12.40 P 12.423 P 12.427
Fair value of call option P 28,200 P 30,780
Questions:

a. The gain/loss on hedging instrument due to change in the ineffective portion on


December 31, 2019.

Intrinsic Value = [(Strike Price – Market Price) x Principal amount]


Time Value = Ineffective Portion

10/5/19 12/31/19 1/30/20


Intrinsic Value 0 26,220 30,780
Time Value 15,700 1,980 0
Fair Value 15,700 28,200 30,780

Time Value, December 31, 2019 P 1,980


Time Value, October 5, 2019 (15,700)
Loss (P 13,720)

b. The gain/loss on hedging instrument due to change in the effective portion on


December 31, 2020.

Intrinsic Value = Effective Portion


Time Value, January 30, 2020 P 30,780
Time Value, December 31, 2019 (26,220)
Gain P 4,560

c. The December 31, 2019 gain/loss in the hedging activity amount to.

Hedging instrument (P28,200 – 15,700) P 12,500


Hedged Item [฿1,140,000 (P12.40-12.423)] (26,220)
Loss (P 13,720)

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