BASIC DERIVATIVES

Related Standards: PFRS 9 (Financial Instruments); PFRS 13 (Fair Value Measurement); PAS 32 (Financial Instruments:
Presentation)

Nature & Concepts

• Derivatives were off-balance sheet items; hence, they were not accounted for separately.
• Derivatives are now required by the reporting standards to be properly accounted and disclosed. This is due to:
o The risks associated with engaging in derivative transactions; and
o Their potential abusive use.
Purpose of Derivatives
• The purpose of obtaining derivatives is either:
o To speculate (incur risk – to commensurate reward; generally discouraged due to high risk); or
o To hedge (avoid or manage risk – mitigate financial risk; more common)

Risk
• It is the possibility that an event will occur which will have an adverse effect on the entity’s achievement of its
achievement.
• Financial risk – the possible future change in interest rate, financial instrument price, index price, credit rating, or other
variables.

PFRS 7 requires quantitative and qualitative disclosures on:

Credit Risk Required
Liquidity Risk Required
Market Risk (Price Risk) Normally required (for financial instruments measured @ FV)
Interest Rate Risks Normally required (for debt instruments with variable interest rate)
Currency Risks Required (for financial instruments measured in foreign currency)

• Credit Risk – Failure of debtor’s discharge of obligation.

• Liquidity Risk – failure of the entity’s ability to meet its obligations.
• Market (or Price) Risk – fair values & future cash flows of a financial instrument will fluctuate because of changes in
market prices.
• Markey risk comprises the following types of risks:
a. Currency Risk – market risk due to changes in foreign exchange rates.
b. Interest Rate Risk – market risk due to changes in market interest rates.
c. Other Price Risk – market risk due to changes in market prices caused by factors specific to the individual financial
instrument or its issuer, or factors affecting all similar financial instruments traded in the market.

Definition of a Derivative

• It is a financial instrument or other contract that derives it values from the changes in value of some other underlying
asset or other instrument.
• It is an executory contract, meaning the performance of which is yet to be executed in the future.
• Reciprocal obligation.
• The future settlement or execution depends on whether the value of an underlying will go up or down.
• When used to manage risks, the buyer of the derivative forgoes potential gains in exchange for security over potential
losses (the preference of no gains rather than suffering losses).

Characteristics of a Derivative

• All of the three characteristics of a derivative:

a. its value changes in response to the change in an underlying;
b. it requires no initial net investment (or very minimal initial net investments); and
c. it is settled at a future date.
• Notes:
o Underlying – specified price, rate, or other variable including its schedules event that may or may not occur. These
are not units but a specification of a single unit.
o Notional Amount – specified unit of measure.
o @ IM, the derivative entails no cost unless an amount is paid for them.
o @ IM, Value of a Derivative = Notional Amount ✗underlying
Common Types of Derivatives
1. Forward Contract
↳ A contract to buy or sell a commodity, security, or foreign currency:
a. At a specified amount or quantity.
b. At a specified future date, and
c. At a price which is agreed upon right now.
Proforma Entries
Forward Contracts (FC) to Sell (for example)
Date of Transaction (DOT)
No Entry → Or Dr. to FC Asset & Cr. to Cr. FC Liability
Balance Sheet Date (BSD)
Loss on FC xx
FC Liability xx
Date of Settlement (DOS) - Net
Cash (squeeze) xx
FC Liability xx → Reduced to 0
Gain on FC xx → Not "unrealized gain" as it is already settled.
Date of Settlement (DOS) - Gross
Cash - LC xx → Notional Amount x Agreed Forward Rate
FC Liability xx
Cash - FC xx → Notional Amount x Spot Rate
Gain on FC xx

2. Futures Contract
↳ Currently not offered in the Philippines due to the absence of a Futures Market.
↳ Has an initial margin deposit “Deposit with Broker” which is a receivable, not a derivative.

Whenever there is a: The Deposit is: Other Terms

Gain Returned FC to Sell Short Position
Loss Offset against the Loss FC to Buy Long Position

Forwards Futures
• Private contracts; most likely Over the Counter. • Traded in a market
• Customized contracts • Standardized contracts
• Arm’s length transaction due to them being private contracts; • The parties may never know each other since they
hence, the parties may know each other only interact through a broker
• Settled through actual delivery of agreed commodity or through • Settled through net cash payment.
net cash payment.

Futures Contracts (FC) to Buy (for example)

Date of Transaction (DOT)
Deposit with Broker xx → A receivable account; an initial margin deposit
Cash xx
Balance Sheet Date (BSD)
Loss on FC xx
FC Liability xx
Date of Settlement (DOS) - Simple Entry
Loss on FC xx → To update the FV of the Derivative
FC Liability xx
FC Liability xx
Cash xx → To return the excess after the offset
Deposit with Broker xx → Offset against loss
Date of Settlement (DOS) - Compound Entry
Cash xx
FC Liability xx → Prior entry to update FV is offset against subsequent entry for its derecognition
Loss on FC xx
Deposit with Broker xx
 3. Option Contract

↳ Gives the holder the right (not obligation) to buy or sell an asset @ a specified price & period in the future.
↳ Only when the rights are exercised by the holder where the writer is obligated to perform his obligation.
o Strike price – agreed price; price of the purchased right.
o Spot rate – quoted price for immediate settlement on an interest rate, commodity, a security, or a
currency.
o Call option – an option to buy (you usually call to purchase something; hence call is to buy).
↳ Option premium – payment to the investment banker for the call option.
↳ Option Premium = Intrinsic Value + Time Value.
↳ The time value of the option is estimated using option pricing models (e.g., Black-Scholes
Model)
o Put option – an option to sell

Strike (Agreed) Price

Type Equal to Market Price Less than Market Price More than Market Price
Call In the money Out of the money
At the money
Put Out of the money In the money
Note:
At the money – the holder is indifferent.
In the money – the holder should exercise; results in gain in exercising.
Out of the money – the holder should not exercise; results in loss in exercising.

Types of Options as to Exercise Date

European Options Can be exercised only @ expiration time.
American Options Can be exercised any time prior to maturity.
Bermudan Options Can be exercised before maturity but on certain pre-determined days.

𝑶𝒑𝒕𝒊𝒐𝒏 𝑷𝒓𝒆𝒎𝒊𝒖𝒎(𝑭𝒂𝒊𝒓 𝑽𝒂𝒍𝒖𝒆) = 𝑰𝒏𝒕𝒓𝒊𝒏𝒔𝒊𝒄 𝑽𝒂𝒍𝒖𝒆 + 𝑻𝒊𝒎𝒆 𝑽𝒂𝒍𝒖𝒆

Intrinsic Value = Spot Rate – Strike Price (Agreed Price on the Option Contract)

Proforma Entries (Consider the concept of Option Premium if Fair Value is not given; Separation of Intrinsic Value & Time
Value is permitted by PFRS 9)
Put Option
Date of Transaction (DOT)
Put Option xx
Cash xx
Balance Sheet Date (BSD)
Loss on Put Option xx
Put Option xx
Date of Settlement (DOS) - Gross
Cash - LC xx → Cash received based on agreed price on the Option Contract
Put Option xx → Based on previous value (@ BSD) since FV of Put Option is ignored as the Spot
Rate is used @ DOS
Cash - FC xx → Cash paid by entity based on the Spot Rate
Gain on Put Option xx → Still the same account title
Date of Settlement (DOS) - Net
Cash xx
Put Option xx
Gain on Put Option xx
Variation: Out of the Money
Loss on Put Option xx → To let the option expire based on its previous value @ BSD
Put Option xx
Call Option
Date of Transaction (DOT)
Call Option xx
Cash xx
Balance Sheet Date (BSD)
Call Option xx → Increase by either Market Price/Intrinsic Value (SR-SP) or the Time Value
Gain on Option xx
Loss on Call Option xx
Call Option xx → Decrease by either Market Price/Intrinsic Value (SR-SP) or the Time Value
Date of Settlement (DOS) - Net
Cash xx → To receive cash if SP is less than the SR
Loss on Call Option xx → Squeezed
Call Option xx → Option Premium (FV) = Intrinsic Val. (SR-SP) + Time Value (Usually Given,
sometimes balancing figure)

4. Swap
↳ Contract where two parties agree to exchange payments in the future based on the movement on some
agreed-upon price or rate.
a. Interest Rate Swap – agreement to exchange future interest payments on a given loan amount.
Usually, one set is based on a Fixed Interest Rate and the other is on a Variable Interest Rate.
b. Foreign Currency Swap – agreement to exchange a sum of money in one currency for another.

Swap Template Year 1 Year 2

Receive Variable XX XX
Pay Fixed (XX) (XX)
Net Cash Settlement – Payment (if negative) or Receipt (if positive) XX (XX) XX (XX)

Proforma Entries
Interest Rate Swap (with gain for example)
Date of Transaction (DOT)
No Entry
Balance Sheet Date (BSD)
Interest Rate Swap xx → Adjust FV of the Swap by multiplying the difference of the Variable & Fixed rates with the
appropriate PV factor (PV of 1 if due only in 1 year)
Gain on Int. Rate Swap xx
Date of Settlement (DOS) - Net
Cash xx → To receive netted amount against the fixed/variable (depending on the given) payment
Interest Rate Swap xx → Reduced to 0 based on the previously computed PV
Gain on Int. Rate Swap xx → Squeezed

Proforma Entries
Interest Rate Swap (Periodic Payment; With loss for example)
Date of Transaction (DOT)
No Entry
Balance Sheet Date (BSD)
Loss on Int. Rate Swap xx → Record the gain/loss @ its PV by multiplying the difference of Variable & Fixed rates to PV
of OA of 1 (or the appropriate factor) @ the Current Market Rate
Interest Rate Swap xx
Periodic Cash Settlement
Interest rate Swap xx → Record cash settlement first before adjusting
Cash xx
Interest Rate Swap xx → Adjust FV of the Swap by multiplying the difference of the Variable & Fixed rates with the
appropriate PV factor (PV of 1 if due only in 1 year)
Gain on Int. Rate Swap xx
Date of Settlement (DOS)
Final Cash Settlement
Cash xx → To receive netted amount against the fixed/variable (depending on the given) payment
Interest Rate Swap xx → Reduced to 0 based on the previously computed PV
Gain on Int. Rate Swap xx → Squeezed
 5. Caps, Floors, & Collars

a. Caps
↳ Set a maximum interest rate that a borrower or bond issuer can pay. If the interest rate rises
above the cap, the seller of the cap must pay the buyer the difference.
b. Floors
↳ Set a minimum interest rate that a borrower must pay. If the interest rate falls below the floor,
the buyer of the floor is entitled to a payment from the seller.
c. Collars
↳ A combination of a cap and a floor that's used to hedge against interest rate fluctuations. A collar
is created by simultaneously purchasing an interest rate cap and selling an interest rate floor.
6. Swaption
↳ An option to swap. Right to enter into a swap at a specified future date at specified terms.

7. Weather Derivative
↳ Contract that requires payment based on environmental or physical variables.

Measurement of Derivatives

• All derivatives are measured @ Fair Value; hence, if a derivative contract (not right) is due more than a year, its PV is
computed.
• The accounting for changes in FV depends on whether the derivative is:
o Not designated as a hedging instrument (for speculation)
o Designated as a fair value hedge; or
o Designated as a cash flow hedge.

Type of Instrument SPPI? BM Classification

Derivative No Irrelevant FVPL
No Irrelevant FVPL
Held for Collection only AC
Non-Derivative Debt
Yes Held for Collection & Sale FVOCI
Other the above mentioned FVPL
Non-Derivative Equity No Irrelevant FVPL unless designated as FVOCI

No Hedging Designation

• Accounted for as HFTS, where its changes in FV is recognized in P/L; hence, it is FVPL.
• Considered as obtained for speculation (to incur risk) based on the direction of the movement of prices, rates, or
other underlying.

Illustrations

Forward Contract

See p. 650

ABC Co. expects the value of the yen to decrease in the next 30 days. Accordingly, on Dec. 15, 20x1, ABC Co. enters into a
30-day forward contract to sell 1,000,000 yens at a forward rate of P0.47. The forward rate on Dec. 31, 20x1 is P0.485, while
the spot rate on Jan. 15, 20x2 is P0.46.
See p. 667

On March 1, 20x1, ABC Co. sold inventory to a foreign company for FC 1,000,000 (FC means foreign currency) when the
spot exchange rate was FC 40: P1. Payment is due on April 1, 20x1.

ABC Co. is concerned about the possible fluctuation in exchange rates, so on this date, ABC Co. entered into a forward
contract to sell FC 1,000,000 to a broker for P25,000. According to the terms of the forward contract, if FC 1,000,000 is wor th
less than P25,000 on April 1, 20x1, ABC Co. shall receive from the broker the difference; if it is worth more than P25,000,
ABC Co. shall pay the broker the difference.

Case #1: If the exchange rate on April 1, 20x1 is FC35: P1, how much is the net cash settlement? Indicate whether it is a
receipt or payment.
 Case #2: If the exchange rate on April 1, 20x1 is FC50: P1, how much is the net cash settlement? Indicate whether it is a
receipt or payment.

Case #3: If the exchange rate on March 31, 20x1 is FC45: P1, how much is the fair value of the interest rate swap? Indicate
whether it is a derivative asset or liability.
See p. 668

ABC Co. does printing jobs for various customers. On January 1, 20x1 ABC Co. forecasted the purchase of 1,000 reams of
paper in the next quarter. The expected purchase date is on April 15, 20x1

ABC Co. expects that the price of paper will fluctuate because of the upcoming elections. Thus, on January 1, 20 x1 ABC Co.
enters into a forward contract to purchase 1,000 reams of paper at a forward rate of P600 per ream. If the market price on
April 15, 20x1 is more than P600, ABC Co. shall receive the difference from the broker. On the other hand, if the market price
is less than P600, ABC Co. shall pay the difference to the broker. The forward contract will be settled net on April 15, 20x1.
The discount rate is 10%.

If the price of paper is P700 per ream on March 31, 20x1, how much is the derivative asset (liability) to be recognized in ABC
Co.'s first quarter financial statements?

See p. 669

ABC Co. produces feeds for hogs and chickens. In its long-term budget completed on November 1, 20x1 , ABC Co. forecasts
a purchase of 100,000 kilos of corn on January 1, 20x3

To protect itself from fluctuation in prices, ABC Co. enters into a forward contract on November 1, 20x1 to purchase 100,000
kilos of corn for P5,000,000 (or P50 per kilo). The forward contract will be settled net on January 1, 20x3.

Requirement (a): What is the notional value of the forward contract?

Requirement (b): If the current market price of corn is P65 per kilo on December 31, 20x1 , what amount of derivative asset
(liability) shall be reported in ABC Co.'s 20x1 year-end financial statements? The appropriate discount rate is 10%.

Requirement (c): If the current market price of corn is P40 per kilo on December 31, 20 * 2 , what amount of derivative asset
(liability) shall be reported in ABC Co.'s 20 * 2 year-end financial statements? The appropriate discount rate is 10%.

Futures

See p. 652
On December 1, 20x1, ABC Co. enters into a futures contract to purchase 1,000 ounces of silver on February 1, 20x2 for
P200 per ounce. The broker requires an initial margin deposit of P20,000. The quoted prices per ounce of silver are as
follows:
1/12/x1 31/12/x1 1/2/x1
200 190 185
See p. 670
ABC Co. has the following futures contract:
Futures Price Market Price
Quantity (1/1/x1) (31/12/x1)
1. "Long" futures contract to purchase gold 100 2,000 1,800
2. "Long" futures contract to purchase silver 200 1,600 1,900
3. "Short" futures contract to sell coffee beans 1,000 250 220
4. "Short" futures contract to sell potatoes 1,500 60 75
Requirement: Compute for the total net derivative asset (liability) on December 31, 20x1.

Options

See p. 655

On December 15, 20x1, ABC Co. purchased a foreign currency put option for P7,500 to sell 1,000,000 yens at P0.47 on
January 15, 20x2.

15/12/x1 31/12/x1 15/1/x1

Spot Rate 0.48 0.49 0.46
Fair Value of Put Option 7,500 5,000 8,000
Requirement: a & b provide the journal entry in gross and net. As a variation, assume that the spot rate on January 15, 20x2 is
0.48.
 See p. 657

On April 1, 20x1, ABC Co. enters into a call option contract with an investment banker which gives ABC Co. the option to
purchase 1,000 XYZ, Inc. shares of stocks at a strike price of P100 per share. The call option expires on July 1, 20x1. ABC
Co. pays the investment banker P600 for the call option. The market price of the XYZ, Inc. shares on April 1, 20x1 is P100
per share.

See p. 671

On May 6, 20x1, ABC Co. entered into a firm commitment to purchase equipment from a foreign company for FC 1,000,000
when the exchange rate was FC 40: P1. Payment is due on June 1, 20x1. ABC Co. is concerned about the possible fluctuation
in exchange rates, so on this date, ABC Co. acquired a call option to purchase FC 1,000,000 for P25,000. ABC Co. paid an
option premium of P1,000.

Case 1: If the exchange rate on June 1, 20x1 is FC 35: P1, how much did ABC Co. save by purchasing the call option?

Case 2: If the exchange rate on June 1, 20x1 is FC 50: P1, how much did ABC Co. save by purchasing the call option?

See p. 672

On March 31, 20x1, ABC Co. acquired for P10,000 a put option which entitles ABC Co. to sell 20,000 units of a commodity
for P220 per unit. The option expires on July 1, 20x1. On July 1, 20x1, the current market price of the commodity is P250 per
unit.

Requirement: How much is the loss on the put option to be recognized by ABC Co. in its 20x1 financial statements?

See p. 673

On Oct. 1, 20x1 , ABC Co. acquired for P10,000 a call option on 20,000 units of a commodity at a strike price of P220 per
unit. The current market prices are:

October 1, 20x1 220

December 31, 20x1 240
March 31, 20x1 (exercise date) 250
Requirements: Compute for the following:

a. Derivative asset (liability) on December 31, 20x1

b. Unrealized gain (loss) on December 31, 20x1
c. Net cash settlement - receipt (payment) - on March 31, 20x2
d. Realized gain (loss) on the call option on March 31, 20x2

See p. 674

On Jan. 1, 20x1 ABC Co. entered into an interest rate swap on a P1,000,000 loan. Under the swap agreement, ABC Co. shall
receive interest at whatever the current market rate of interest is at the beginning of the year and pay fixed interest at_10%.
Swap payment shall be made on Dec. 31, 20x2 , i.e., maturity date. The current rates were 10% on Jan. 1, 20x1 and 8% on
Jan. 1, 20x2

Requirement: How much is the net cash receipt. (payment) at maturity date and what amount of derivative asset (liability) is
presented in the Dec. 31, 20x1 statement of financial position?

Swaps

See p. 660
ABC Co. believes that market rates will increase in the future. Thus, on January 1, 20x1, ABC Co. enters into an interest rat e
swap on a P1,000,000 loan whereby ABC Co. agrees to receive variable interest and pay fixed interest of 8%. The interest rate
swap will be settled net on Dec. 31, 20x2.
See p. 662
ABC Co. believes that market rates will increase in the future. Thus, on Jan. 1, 20x1 , ABC Co. enters into an interest rate
swap on a P1,000,000 loan whereby ABC Co. agrees to receive variable interest and pay fixed interest of 9%. Swap payments
shall be made every Dec. 31 in the next three years. The following are the current market rates:
Jan. 1, 20 x1 9%
Jan. 1, 20x2 8%
Jan. 1, 20x3 12%
See p. 665
The current rate on January 1, 20x1 is 10%. ABC Co. believes that market rates will decrease in the future. Accordingly, on
January 1, 20x1, ABC Co. enters into an interest rate swap on a P1,000,000 loan whereby ABC Co. agrees to receive fixed
interest of 10% and pay variable interest. Swap payments shall be made at the end of each year in the next three years. The
following are the current market rates:
Jan. 1, 20 x1 10%
Jan. 1, 20x2 12%
Jan. 1, 20x3 14%