Derivatives

• Derivative is 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 exchange of promises between parties for future action.
• On inception, derivative financial instruments give one party contractual
right to exchange financial asset or financial liability with another party under
conditions that are potentially favourable.
 Purpose of Derivatives
• Entities use derivative financial instruments to manage financial risk.
• Financial risk may originate from the following
• 1. Change in commodity price
• 2. Change in cash flow
• 3. Foreign currency exposure
 Types of financial risk
• 1. Price risk
• 2. Credit Risk
• 3. Interest rate risk
• 4. Foreign currency rate risk
 Hedging
• It is 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 simply means, hedging is a means of protecting a financial loss or the
structuring of a transaction to reduce risk.
 Types of Hedging
• 1. Fair Value Hedge
• 2. Cash flow hedge
• 3. Hedge of a net investment in a foreign operation
 Components of Hedging
• 1. Hedged Item – is an asset, liability, firm commitment, highly probable
forecast transaction or net investment in a foreign operation.
• 2. 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.
 Measurement of Derivatives
• An entity shall recognize and measure all derivatives as either asset or liability
at fair value.
• Both the fair value and notional shall be fully disclosed.
• An unrealized gain or loss is recognized when there is change in the fair
value.
 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
transactions.
• The derivative or hedging instrument is measure at fair value.
• Change in fair value is recognized as component of other comprehensive income
• The ineffective portion is recognized in profit or loss
• The hedged item is not adjusted to conform with fair value.
 Interest rate swap
• It 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 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.
• It is a commitment to purchase or sell a specified commodity on a future
date at a specified price.
 Futures Contract
• A future contract is a contract to purchase or sell a specified commodity at
some future date at a specified price.
• The difference of futures contract and forward contract is that the future
contract is traded in a futures exchange market in much the same manner as
debt and equity securities being traded in the stock market.
 Options
• 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.
• It is a right and not an obligation to purchase or sell.
• Call option gives the holder the right to purchase an asset
• Put option gives the holder the right to sell an asset.