REVIEWER IN DERIVATIVES instrument or its issuer, or

factors affecting all similar

INTRODUCTION TO DERIVATIVES – Derivatives financial instruments traded in
were considered off-balance sheet items; they the market.
were not separately accounted for in the
financial statements. However, because of the Derivatives – a financial instrument or other
risks inherent in engaging in derivative contract that derives its value from the changes
transactions and their potential for abusive use, in value of some underlying asset or other
reporting standards now require proper instrument.
accounting and disclosure of derivatives.
CHARACTERISTICS OF A DERIVATIVE
PURPOSE OF DERIVATIVES
a. Its value changes in response to the
a. to speculate (incur risk); or change in an underlying.
b. to hedge (avoid or manage risk) b. It requires no initial net investment (or
• the use of derivatives to speculate are only a very minimal initial net
highly discouraged because of the high investment).
risk associated with it. Derivatives are c. It is settled at a future date.
used to manage risks, particularly
financial risks. Underlying – specified price, rate, or another
variable (e.g., interest rate, security or
Risk – the possibility that an event will occur commodity price, foreign exchange rate, index of
having an adverse effect on the achievement of prices or rates, etc.), including a scheduled event
entity’s objectives. (e.g., a payment under contract) that may or may
- it is measured in terms of impact (possible loss) not occur.
and likelihood (probability).
Notional amount – a specified unit of measure
Financial risk – the risk of a possible future (e.g., number of currency units, number of
change in interest rate, financial instrument shares, kilos, pounds, etc.)
price, index price, credit rating, or another
variable. COMMON TYPES OF DERIVATIVES

TYPES OF FINANCIAL RISK 1. Forward contract – an agreement

between two parties to exchange a
1. Credit risk – the risk that one party to a specified amount of a commodity,
financial instrument will cause a security, or foreign exchange currency at
financial loss for the other party by a specified date in the future at a
failing to discharge an obligation. specified price or exchange rate.
- it includes the possibility that an entity - a forward is a contract to buy or sell a
cannot collect on its receivables. commodity, security, or foreign
currency:
2. Liquidity risk – the risk that an entity will a. At a specified amount or
encounter difficulty in meeting quantity,
obligations associated with financial b. At a specified future date, and
liabilities that are settled by delivering c. At a price which is agreed upon
cash or another financial asset. right now.
- it includes the possibility that an entity
cannot pay its payables. 2. Future contract – is a contract to
purchase or sell a specified commodity
3. Market risk – the risk that the fair value at some future date at a specified price.
or future cash flows of a financial - It is traded in a future exchange market
instrument will fluctuate because of in much the same manner as debt and
changes in market price. equity securities being traded in stock
a. Currency risk – will fluctuate market.
because of changes in foreign
exchange rates. 3. Option – contract that gives holder the
b. Interest rate risk – will fluctuate right to purchase or sell an asset at a
because of changes in market specified price during a definite period at
interest rates. some future time. An option is a right
c. Other price risk – will fluctuate and not an obligation to purchase or sell.
because of changes in market
prices, whether those changes Types of options as to exercise date
in are caused by factor specific
to the individual financial
 a. European options – can be - Interest rate goes up, the entity would
exercised only at expiration enter cap; Interest rate goes down, the
date. entity would enter floor; Meanwhile,
b. American options – can be collar is the fixation of both cap and
exercised any time prior at floor.
maturity.
c. Bermudan options – can be 6. Swaption – an option on a swap. The
exercised before maturity but option provides the holder with the right
on certain pre-determined days. to enter a swap at a specified future date
at specified terms. This derivative has
Types of options as to right of holder characteristics of an option and a swap.
a. Call option – an option to buy.
- it gives the holder the right to 7. Weather derivative – a contract that
purchase an asset. requires payment based on climatic,
b. Put option – an option to sell. geographical, or other physical variables.
- it gives the holder the right to
sell an asset. Measurement of Derivatives – all derivatives are
measured at fair value. The accounting for the
At the money – the holder may or may changes in fair value depends on whether the
not be exercise the option, no gain or derivative is:
loss in exercising. 1. Not designated as a hedging
instrument.
In the money – the holder should 2. Designated as fair value hedge; or
exercise, gain in exercising. 3. Designated as cash flow hedge.

Out of the money - the holder should No hedging designation – Derivatives that are
not exercise, loss in exercising. not designated as hedging instruments are
considered obtained for speculation on the
Type of Strike Strike Strike direction of the movement of prices, rates or
Option Price = Price <Price > other underlying.
Market Market Market - Non-designated derivatives are accounted for
Price Price Price as held for trading securities.
Call At the In the Out of - Changes in fair values are recognized in profit
(Buy) Money Money the or loss (i.e., FVPL)
Money
Put At the Out of In the Embedded derivative – is a component of a
(Sell) Money the Money hybrid or combined contract with the effect that
Money some of the cash flows of the combined contract
vary in way like a stand-alone derivative.
4. Swap – a contract in which two parties
agree to exchange payments in the Examples of embedded derivative
future based on the movement of some
agreed-upon price or rate. 1. Equity conversion option in a
a. Interest rate swap – a contract convertible bond instrument that allows
in which two parties who agree the holder to convert the bond into
to exchange future interest shares of the issuer.
payments on a given loan - The convertible bond instrument is the
amount. One set of interest host contract, and the equity conversion
payments is based on a fixed feature is the embedded derivative.
interest rate and other is based
on a variable interest rate. 2. Redemption option in an investment in
b. Foreign currency swap – a redeemable preference share that
contract between two parties allows the issuer to repurchase the
who agree to exchange a sum of preference share.
money in one currency for - The investment in redeemable
another currency. preference share is the host contract
and the redemption option feature is the
5. Caps, floors, and collars – essentially embedded derivative.
options designed to shift the risk of an
upward and/or downward movement in 3. An investment in bond whose interest or
variables, such as interest rates. These principal payment is linked to the price
are normally linked to a notional amount of gold or silver.
and a reference rate. - The investment in bond is the host
contract and the embedded derivative is
 the payment of interest or principal
based on the price of gold or silver.

Embedded derivative accounted for separately

– Bifurcation is the process of separating an
embedded derivative from the host contract.