Derivatives

• Derivatives


  Financial instruments or other contracts that derive their value from the changes in the value of some other underlying asset or other instrument
• Derivatives


  • Its value changes in response to the change in an underlying
  • It requires no initial net investment (or only very minimal initial net investment)
  • It is settled at future date
• Underlying


  A specified price, rate, or other variable (e.g. interest rate, security or commodity price, FX rate, index price or rates), including a scheduled event (e.g. payment under contract) that may or may not occur
• Notional amount


  A specified unit of measure (e.g. number of currency units, number of shares, kilos, pounds, etc.)
• Derivatives


  • Most derivatives are not recorded at the date of initial transaction unless an amount is paid for them
  • After initial date of transaction, the value of the derivative is determined by multiplying (or other arithmetical interaction) the notional amount by the underlying
• Common types of derivatives

  • Forward contract
  • Future contract
  • Option
  • Swap
  • Caps, floors and collars
  • Swaption
  • Weather derivative
• Forward contract


  An agreement between two parties to exchange a specified amount of commodity, security, or foreign currency at a specified date in the future in a pre-agreed price
• Future contract


  A contract traded on an exchange that allows an entity to buy or sell a specified quantity of commodity or a financial security at a specified price on a specified future date
• Option


  A contract that gives the holder the right, but not the obligation, to buy or sell an asset at a specified price ("strike price") any time during a specified period in the future
• Types of options as to exercise date

  • European options - Exercise only at expiration date
  • American option - Exercise anytime prior to maturity date
  • Bermudan option - Exercise before maturity but on certain predetermined days
• Types of options as to right of holder

  • Call option - option to buy
  • Put option - option to sell
• At the money


  The holder may or may not exercise the option, no gain or loss in exercising
• In the money


  The holder should exercise; gain in exercising
• Out of the money

  The holder should not exercise; loss in exercising
• Swap


  A contract in which two parties agree to exchange payments in the future based on movement of some agreed-upon price or rate (e.g. interest rate swap or foreign currency swap)
• Caps, floors and collars


  Options designed to shift the risk of an upward and/or downward movement in variables, such as interest rates. These are normally linked to a notional amount and a reference date
• Swaption


  Has characteristics of an option and a swap
• Weather derivative


  A contract that requires payment based on climatic, geological or other physical variables
• Measurement of derivatives


  All derivatives are measured at fair value. The accounting for the changes in fair value depends on whether the derivative is not designated as a hedging instrument, designated as fair value hedge, or designated as cash flow hedge
• Not designated as a hedging instrument

  Derivatives that are not designated as hedging instruments are considered obtained for speculation on the direction of the movement of prices, rates or other underlying. Non-designated derivatives are accounted for as held for trading securities. Changes in fair values are recognized in profit or loss.
• Investment in Associates


  When equity method is discontinued, all amounts previously recognized in OCI in relation to the investment are either reclassified to P&L as a reclassification adjustment or transferred directly to retained earnings
• PAS 28 does not permit an investor that continues to have significant influence over an associate not to apply the equity method when the associate is operating under severe long-term restrictions that significantly impair its ability to transfer funds to the investor. Significant influence must be lost before an entity ceases to apply the equity method.
• Change to Equity Method - Gaining Significant Influence


  Significant influence may be achieved from additional purchase of shares resulting to an increase in ownership interest. Account for this by reference to PFRS 3 Business Combinations.
• Intercompany Sales with an Associate

  Gains and losses resulting from "downstream" and "upstream" transactions between an entity and its associate are recognized in the entity's financial statements only to the extent of unrelated investor's interest in the associate.
• Impairment Losses


  Goodwill arising from an investment in associate is simply included in the carrying amount of the investment and not accounted for separately (so it is neither amortized nor tested for impairment separately). The investment in associate is tested for impairment under PAS 36 Impairment of Assets by comparing the investment's carrying amount (which includes the goodwill) with the investment's recoverable amount. Any resulting impairment loss is not allocated to any asset, even to goodwill. Instead, it is treated as a decrease in the carrying amount of the investment, to which goodwill is included.
• Forward contract


  A contract between two parties to buy or sell an asset at a predetermined price and date in the future.
• Future contract


  A standardized and exchange-traded contract to buy or sell a commodity or financial instrument at a predetermined price and date in the future.
• Option


  A contract that gives the buyer the right, but not the obligation, to buy or sell an asset at a predetermined price within a specific time period. There are two types of options: calls (right to buy) and puts (right to sell).
• Swap


  A contract in which two parties agree to exchange cash flows over a period of time, based on the underlying asset or reference rate. There are various types of swaps, including interest rate swaps, currency swaps, and commodity swaps.
• Cap


  An option that sets a maximum price for the underlying asset.
• Floor


  An option that sets a minimum price for the underlying asset.
• Collar


  An option that sets both a maximum and minimum price for the underlying asset.
• Swaption


  An option to enter into a swap agreement at a future date. It gives the buyer the right, but not the obligation, to enter into a swap at a predetermined price and date.
• Weather derivative


  A financial instrument that allows parties to transfer weather-related risks. It is often used by businesses that are sensitive to weather conditions, such as energy companies and agriculture producers.
• At the money (ATM)

  An option contract where the strike price is equal to the current market price of the underlying asset
• Out of the money (OTM)


  An option contract that has no intrinsic value because the strike price is not equal to the current market price of the underlying asset
• Out of the money call option

  A call option where the strike price is higher than the current market price of the underlying asset
• Out of the money put option


  A put option where the strike price is lower than the current market price of the underlying asset
• Current Risk 


  risk that the fair value of future cash flows of one financial instrument will fluctuate because of changes in foreign exchange rates
• Interest rate risk


  Risk that the fair value of future cash flows of one financial instrument will fluctuate because of changes in market interest rates