HEDGES OPERATIONS AND DERIVATIVES ACCOUNTING

OUTLINE
1. Introduction
2. Types and Uses of Derivative Instrument
3. Types of Hedges
4. Forwards and Future
5. Currency Swaps
6. Options
7. Rights
8. Warrants
9. Disclosure Requirements
10. Conclusion
11. Further Illustrations

1.0 INTRODUCTION
Derivative instruments are assets or liabilities that are recorded on
the statement of financial position at fair value. They are assets that
derive their values from prices of underlying assets which can be
shares bonds, commodities, foreign currencies, interest rates.
A typical derivative instrument has the following characteristics
- Underlying and notional amount or payment provisions
- There is an initial net investment required
- Provides for net settlement at a future date.
For avoidance of doubt, the following items cannot be described as
hedge or derivative transactions.
- Normal purchases and sales
- Insurance contracts including Life Insurance
- Financial guarantee contracts
- Investment contracts
- Loan commitments

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 - Leases etc.
Derivatives and hedging therefore include only the following items.
- Forward commitments
- Forward and option contracts for the purchase or sale of debt and
security instruments
- Loan commitments

2.0 TYPES AND USES OF DERIVATIVES INSTRUMENT

The main types of financial derivative instruments are:
(i) Forwards
(ii) Futures
(iii) Swaps
(iv) Options
(v) Right and
(vi) Warrants
Broadly speaking and according to Ade Omolehinwa (2000), the uses
of financial derivatives include:
- Hedging the cost of future financing
- Protect the price of a financial asset to be sold in the future
- Avoid exposure to large price variation
- Allow risk averse investors to minimize exposure
- Reduce income volatility created by fluctuations in interest rates
- Hedging commitment to lend money in the future
- Hedging risk of changes in foreign exchange rate.

3.0 HEDGING AND TYPES AVAILABLE

Hedging allows a person to minimize or avoid risks inherent in a
financial transaction by using derivative instruments
The following three types of hedges are recognized.
(i) Fair Value Hedge: A deliberate action to minimize or avoid
possible change in the fair value of an asset or liability by
seeking to avert the inherent risk

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 (ii) Cash Flow Hedge: This is an action to influence positively the
possible variations in the cash flows likely to arise from an asset
or liability due to a particular risk.
(iii) Net Investment Hedge: Action to protect net investment in a
foreign transaction or operation as a result of possible
exchange rate fluctuation.
In order to use hedge accounting, the following five general criteria
will apply.
(a) The transaction or item should be eligible i.e. only recognized
assets or liabilities are eligible to be so designated
(b) The applicable risk to the item or transaction should be eligible
i.e. should be only one and avoidable if action is taken. These
risks differ between financial and non-financial items and
include broadly interest rate, credit, foreign currency and price
risks
(c) The hedging instrument to be used should be eligible.
(d) Hedging as an option should be effective before it’s adoption.
(e) There is need to formally and properly document the hedge
transaction.

4.0 FORWARD AND FUTURES

A forward contract is the purchase or sale of a financial instrument
such as security, commodity or foreign currency at a price agreed
now for delivery and payment at a specified date in the future.
Forward contracts have the challenges of possible failure to perform
by one of the contracting parties, difficulty in finding a partner with
opposite expectation and the need for the original parties to be
available to honour their obligation at the agreed period.
Future contract is a forward contract with a difference in the sense
that it is traded on a recognized stock exchange and the term must
comply with the rules of the exchange. Future contract therefore
ensure standardize contract terms unlike tailor made arrangements
common in forward contracts. Furthermore, in future contracts, the

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 performance of contracted obligation is guaranteed as the parties are
compelled to meet up with their obligation in compliance with the
exchange rules.

5.0 CURRENCY SWAPS

This involves an arrangement to exchange a set of future cash flows
receivable by one of the parties.
The cash flows can be interest receivable on debt instruments or
foreign currencies receivable in the future.

Illustration 1
A invested ₦10million Naira in FGN Bond paying interest at the rate
of 15% for the next ten years.
A can negotiate the right to receive the yearly interest and even the
terminal value with B for an agreed value. Once A is paid the agreed
sum, B steps in to receive the yearly interest and the terminal value
payable.

Illustration 2
X Ltd based in Nigeria has opened a confirmed irreversible letter of
credit in favour of Z Ltd based in Germany for US$150,000 in respect
of an import transaction.
After proper execution of all the relevant documents, Z Ltd in need of
urgent funds can negotiate with a financial institution based in
Germany to receive the proceeds of the letter of credit in exchange
for immediate payment of an agreed sum.

6.0 OPTIONS
An option is a form of derivative instrument in which two parties
agree to exchange an asset for an agreed price at a future fixed
date.

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 A typical option gives the owner right to either buy or sell an asset at
an agreed price, but the owner or holder of the option is not
obligated to exercise the option.
An option can be a call or put option. It is a call option where the
owner or holder is having right to purchase the asset from the seller.
On the other hand, it would be a put option where the holder or
owner of option has the right to sell the asset at a future date.

7.0 RIGHTS
This is a short-term opportunity given for the purchase of the shares
of a company. The right is normally extended to existing shareholder
who are expected to buy a given number of share in proportion to
that already held e.g. Right to buy 2 new shares for every 5 shares
already held.
It may be noted that to make rights attractive, they are offered at a
price that is lower than the current market price of the share
concerned.
Furthermore, rights can be traded and sold by the shareholders
entitled to receive it.

8.0 WARRANTS
A warrant is an instrument that confers a long term right to buy the
share of company at a specified price at an agreed future date.
Warrants can be sold alone or they can be embedded in debt or
preferred shares offered to the public in order to make them more
attractive to the investing public.
There is usually a formal agreement to back-up issue of warrants that
will specify agreed terms such as price, voting rights etc. warrant is
therefore a form of option.
The inclusion of warrants in a loan stock issue makes it more
attractive. Also interest rate on such loan stock will be relatively
lower.

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9.0 DISCLOSURE REQUIREMENTS
IAS37 on Provisions, Contingent Assets and Liabilities
Forward or Hedge contracts for which there is a reasonably certain
obligation to be met in the future should be provided or adjusted for
in financial statements as Assets or Liabilities. Items that are
reasonably uncertain with respect to timing or amount or that are
subject to future probable event should only be disclosed by way of
notes to the financial statements as contingent assets or contingent
liabilities with brief description of the nature of item and explanation
of uncertainty surrounding the item

10.0 CONCLUSION
Financial Derivatives are still evolving all over the globe as new
products continue to emerge. With recent technological
advancements, the developed economics continued to find ways to
deepen their financial systems through the use of innovative financial
instruments.
The third world and developing economies all need brace up to this
challenge by equally coming with financial derivative instruments that
would be suitable to their situations.

11.0 FURTHER ILLUSTRATIONS

A. Dangote Refinery Plc require a working capital loan of ₦5 billion for
its new Lekki Refinery. The refinery is scheduled for completion by
December 31, 2021 and formal operations and production expected
to commence immediately with effect from January 1, 2022. The
borrowing rate is presently 15% per annum.
Dangote refinery can choose to wait till January 1, 2022 and pay the
interest rate ruling by then. Alternatively, it can enter into a hedge
contract to borrow the required N5 billion ahead at 15% for delivery
by January 1, 2022. If the rate had determinate to say 20% by then,
Dangote Refinery Plc will still obtain the ₦5 billion loan at 15% per
annum.

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 B. ABC Pension Ltd would need to meet pension obligations of new
retirees in three months to the tune of ₦100 million. There is need
to dispose part of the shares in it’s portfolio to meet this obligation.
The company has option of waiting till 3 months to sell sufficient
shares to raise the needed ₦100 million.
However, if there is possibility of the price of shares fluctuating
adversely, then the company can enter into a forward contract to
sell the shares at the ruling market price today for eventual delivery
and payment in three months.
C. NNPC has a firm contract to deliver US$500,000 worth of crude oil to
an Australian firm in six months.
NNPC can wait for the receipt of the $500,000 in six months and
convert to Naira using exchange rate at that time.
However, if there is concern of possible adverse movement in
exchange rate before the six months, then NNPC can sell the
$500,000 through a forward contract at an exchange rate agreed
and firmed up today for delivery and payment in six months.

12.0 REFERENCES
1. KPMG: Derivatives and Hedging Handbook
2. Ade Omolehinwa : Work Out Corporate Finance (Revision and
Worked Examples (2000)
3. Pye: Corporate Finance and Financial strategy (1998)

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