pert 1 & 2 - derivative-complete

1

Edited by Taufik Hidayat

Session 1 and 2

Accounting for Derivative

Instruments


Agenda

1. Financial Intruments and Derivative.

2. Forward Contracts.

3. Future Contracts.

4. Hedge using forward and future contracts.

5. Option.

6. Swap.

7. Hedge using option and swap.

Session 1

Session 2

2


Financial Instruments

• Financial instrument is formally defined in PSAK 50 while PSAK 55

refers to the same definition as follows:

• A financial instrument is any contract that gives rise to

– a financial asset of one entity and

– a financial liability or equity instrument of another entity.

Financial instrument

Financial asset

Financial liability

Equity instrument or

of one entity

of another entity


Financial Instruments (2)

Financial asset is any asset that is:

• Cash

• An equity instrument of another entity

• A contractual right

i) to receive cash or another financial asset from another entity

ii) to exchange financial assets or financial liabilities with another entity under

conditions that are potentially favourable to the entity

• A contract that will or may settled in the entity’s own equity instruments and is

i) a non-derivative for which the entity is or may be obliged to receive a variable

number of the entity’s own equity instruments; or

ii) a derivative that will or may be settled other than by the exchange of a fixed

amount of cash or another financial asset for a fixed number of the entity’s

own equity instruments. For this purpose the entity’s own equity instruments

do not include certain instruments,

• say specified puttable financial instruments, or instruments that are

contracts for the future receipt or delivery of the entity’s own equity

instruments


Financial asset

3


Financial Instruments (3)

Financial liability is any liability that is

• A contractual right

i) to deliver cash or another financial asset from another entity

ii) to exchange financial assets or financial liabilities with another

entity under conditions that are potentially unfavourable to the entity

• A contract that will or may settled in the entity’s own equity instruments and is

i) a non-derivative for which the entity is or may be obliged to deliver a variable

number of the entity’s own equity instruments; or

ii) a derivative that will or may be settled other than by the exchange of a fixed

amount of cash or another financial asset for a fixed number of the entity’s

own equity instruments. (For this purpose, certain other conditions are

required to observe)


Financial liability


Definition of Derivative

is a financial instrument or other contract within the

scope of PSAK 55 with all 3 of the following

characteristics:

a) its value changes in response to the change in a

specified interest rate, financial instrument price,

commodity price, foreign exchange rate, index of prices

or rates, credit rating or credit index, or other variable

(sometimes called the ‘underlying’);

b) it requires no initial net investment or an initial net

investment that is smaller than would be required for

other types of contracts that would be expected to have a

similar response to changes in market factors; and

c) it is settled at a future date.

Value change based on an underlying

Little or no initial net investment

Settled at a future date

Derivative

4


Derivative Instruments Example

• Melody Limited makes a five-year fixed rate loan to Tony Inc, while

Tony at the same time makes a five-year variable rate loan for the

same amount to Melody.

• There are no transfers of principal at inception of the two loans, since

Melody and Tony have a netting agreement.

• Is this a derivative under PSAK 55?

Yes.

• This meets the definition of a derivative (that is to say, there is an

underlying variable, no initial net investment or an initial net investment

that is smaller than would be required for other types of contracts that

would be expected to have a similar response to changes in market

factors, and future settlement).


Derivative Instruments (2)

Types of derivative

instruments

Underlying Used by

Option contracts

(call and put)

Security price Producers, trading firms,

financial institutions, and

speculators

Forward contracts

e.g. foreign exchange

forward contract

Foreign

exchange rate

Various companies

Future contracts

e.g. commodity futures

Commodity

prices

Producers and

consumers

Swaps Interest rate Financial institutions

Example of derivative instruments and their underlying

5


Derivative Instruments (3)

• Use of derivatives

1. Manage market risk

2. Reduce borrowing cost

3. Profit from trading or speculation

• Types of derivatives

1. Forward type derivatives such as forward contracts,

future contracts and swaps

2. Option-type derivatives such as call and put options,

caps and collars and warrants

3. Free standing derivatives

4. Embedded derivatives


Compound Financial Instrument &

Embedded Derivative

• There are certain financial instruments that have a

hybrid or combined nature.

• For example, a convertible bond is a debt instrument

with an embedded option to convert the debt

instrument to equity shares.

– From the perspective of the issuer, the debt instrument is a

financial liability while the embedded option may be an

equity instrument.

– From the perspective of the holder of that convertible bond,

the debt instrument is a financial asset and the embedded

option is similar to a derivative.

6


Compound Financial Instrument &

Embedded Derivative

• In PSAK 50, from the perspective of an issuer, these

kinds of financial instruments are termed as compound

financial instruments.

– PSAK 50 requires an issuer of a compound

financial instrument to separately classify different

components of the instrument in accordance with the

definition of financial liability and equity instrument.

• In PSAK 55, from the perspective of a holder, these kinds

of financial instruments are termed as hybrid (combined)

instruments.

– PSAK 55 requires a holder of a hybrid instrument to

separately account for the embedded derivative of

the instrument if certain conditions are fulfilled.

Will be discussed in

session 3


Initial Recognition

• Initial recognition requirements for financial

assets and financial liabilities in PSAK 55:

• An entity is required to recognise a financial

asset or a financial liability on its balance

sheet when, and only when, the entity

becomes a party to the contractual

provisions of the instrument.

• In other accounting standards, the

recognition criteria are

1) it is probable that future economic benefits

associated with the item will flow to (or flow out

from) the entity; and

2) the cost of the item can be measured reliably.

Imply trade date

accounting

Imply settlement

date accounting

7


Initial Recognition (2)

• The settlement date is the date that an asset is delivered

to or by an entity.

• The trade date is the date that an entity commits itself to

purchase or sell an asset.

• The recognition criteria in PSAK 55 require an entity to

recognise financial asset or financial liability when it

becomes a party to the contractual provisions of the

instruments.

– These criteria imply an entity to recognise financial asset or

financial liability on a trade date basis.


Initial Recognition (3)

• In consequence of the recognition criteria of PSAK 55, all

the financial assets and liabilities, including derivatives

(such as options and futures), become “on-balance sheet”

from the trade date.

– In other words, an entity is also required to recognise all of its

contractual rights and obligations under derivatives in its balance

sheet as assets and liabilities.

• PSAK 55 specifically states that a contract that requires or

permits net settlement of the change in the value of the

contract (such as derivative contract) is not a regular way

contract.

– Such contract is accounted for as a derivative in the period

between the trade date and the settlement date.

8


Initial Measurement

• When a financial asset or financial liability (except for it at

fair value through profit or loss) is recognised initially, an

entity is required to measure it at:

1. its fair value plus

2. its transactions costs that are directly attributable to

the acquisition or issue of the financial asset or

financial liability.

• In the case of a financial asset or financial liability that

will be classified as financial asset or financial liability

at fair value through profit or loss (FVTPL),

1. an entity is only required to measure it at its fair value

only

2. its transaction costs should not be recognised.

Derivative FVTPL


Initial Measurement (2)

• Fair value is the amount for which an asset could be

exchanged, or a liability settled, between knowledgeable,

willing parties in an arm’s length transaction.

• New definition of Fair Value based on PSAK 68: Fair

Value is defined as the price that would be received to

sell an asset or paid to transfer a liability in an orderly

transaction between market participants at the

measurement date.

• Transaction costs are incremental costs that are directly

attributable to the acquisition, issue or disposal of a

financial asset or financial liability. An incremental cost is

one that would not have been incurred if the entity had

not acquired, issued or disposed of the financial

instrument.

9


Subsequent Measurement

• Default accounting treatment for derivatives under PSAK 55:

– Derivatives are classified under the Fair Value through Profit or Loss

category and changes in their fair values are taken to income

statement

– Exception - when a derivative is designated as a hedge of an

identified risk and the hedge is effective. In this case, accounting for

the derivative follows hedge accounting rules.

• Financial instrument at fair value through profit or loss

(including derivative) is initially recognised at fair value only.

• After initial recognition, an entity is required to measure

financial instrument at fair value through profit or loss

(including derivative) at their fair values.


Derecognition of a Financial Asset

• The general derecognition criteria in accordance with PSAK

55 require an entity to derecognise a financial asset when,

and only when:

1. the contractual rights to the cash flows from the financial asset

expire; or

2. the entity transfers the financial asset that meet the conditions set

out in PSAK 55 (i.e. “asset transfer test”) and

the transfer qualifies for derecognition in accordance with PSAK 55

(i.e. the “risks and rewards test” and the “control test”).

10


Derecognition of a Financial Liability

• An entity is required to remove a financial liability (or a part

of a financial liability) from its balance sheet (i.e.

derecognise a financial liability) when, and only when, it is

extinguished.

– PSAK 55 explains that a financial liability is extinguished when the

obligation specified in the contract is discharged or cancelled or

expires.

• A financial liability or part of it is extinguished when the

debtor either:

1. discharges the liability or part of it by paying the creditor, normally

with cash, other financial assets, goods or services; or

2. is legally released from primary responsibility for the liability (or part

of it) either by process of law or by the creditor.


Forward Contracts

• An agreement between two parties (counterparties) whereby one

party agrees to buy and the other party agrees to sell a specified

amount (notional amount) of an item at a fixed price (forward

rate) for delivery at a specified future date (forward date).

• Can either be a forward purchase contract or a forward sales

contract, depending on the perspective of the counterparties.

“A” Company “B” Company Sells Forward

Contract

“Forward sales contract” “Forward purchase contract”

11


Forward Contracts (2)

• Not standardized contracts as they are not traded on an

exchange

– They entail counterparty risks

– They are can be tailored to specific needs of counterparties

– They involve lower transaction costs

• Fair value of forward contract:

Notional

amount x

(Current forward rate – contracted forward rate)

(1+r) t

where

Contracted forward rate is forward rate

fixed at inception

Current forward rate is forward rate for

remaining period to maturity

r = discount rate

t = period to maturity


Forward Contracts: Journal Entries

At inception During life of contract Closing position or

at expiration*

No journal entry

as fair value is nil

Dr Forward Contract

(asset)

Cr Gain on forward

contract

Dr Loss on forward

contract

Cr Forward Contract

(liability)

or

Adjust fair value and

record gain/loss

Close out and record

net settlement of

contract

Dr Cash

Cr Forward contract

Dr Forward contract

Cr Cash

* It’s also required the journals to adjust fair value and settlement of underlying at expiration.

12


Forward Contracts : illustration

• On March 1, 20X5, Company A entered into a forward contract

with a foreign exchange dealer to buy 1 million foreign currency

(FC 1,000,000) for delivery on May 30, 20X5. Following

exchange rates are given:

Example

Date Spot rate

$/FC

May 30 forward rate

$/FC

March 1 $1.185 $1.20

March 31 1.19 1.21

April 30 1.20 1.205

May 30 1.215 1.215


Forward Contracts: illustration (2) Example

Date Account Amount

March 1 No Entry Fair value of forward contract is zero at inception

March 31 Dr Forward Contract (asset)

Cr Gain on Forward Contract To record change in fair value of forward contract

10,000

10,000 (1.21 - 1.2) x 1,000,000

April 30 Dr Loss on Forward Contract

Cr Forward Contract (liability) To record change in fair value of forward contract

5,000

5,000 (1.21 - 1.205) x 1,000,000

May 30 Dr Forward Contract (asset)


Dr Cash

Cr Forward Contract To close forward contract at maturity

Dr Foreign Currency

Cr Cash To record settlement of underlying

10,000

10,000 (1.215 - 1.205) x 1,000,000

15,000

15,000 (1.2 - 1.215) x 1,000,000

1,215,000

1,215,000 1.215 x 1,000,000

• When forward contracts fall due more than 12 months after the reporting period, they should be

discounted.

13


Forward Contracts: illustration (3) Example

Date Account Amount

March 1 No Entry Fair value of forward contract is zero at inception

March 31 Dr Forward Contract (asset)


10,000

10,000 (1.21 - 1.2) x 1,000,000

April 30 Dr Loss on Forward Contract

Cr Forward Contract (liability) To record change in fair value of forward contract

5,000

5,000 (1.21 - 1.205) x 1,000,000

May 30 Dr Forward Contract (asset)


Dr Foreign Currency

Cr Cash

Cr Forward Contract To close forward contract at maturity

10,000

10,000 (1.215 - 1.205) x 1,000,000

1,215,000

1,200,000

15,000* *(1.2 - 1.215) x 1,000,000

Alternative journal entries:


Futures Contracts

• A future contract is similar to a forward contract except that

it is a standardized contract and is traded on an exchange.

• Futures contracts are marked-to-market and settled on a

daily basis.

• Futures contracts require payment of a margin deposit

which has to be maintained throughout the contract period.

• Margin account is not part of initial investment but as

collateral for counterparty or clearinghouse.

• Margin accounts are separate assets and accounted

separately.

• Wide range of exchange-traded future contracts:

• Commodity futures

• Interest rate futures

• Currency futures

14


Futures Contracts: Journal Entries


at expiration*

Dr Futures Contract

Cr Gain on future

contract

Dr Loss on future

contract

Cr Futures Contract

or

Record daily settlement of

future contracts

Close out and and recover

margin deposit

Dr Cash

Dr Gain on future

contract

Cr Margin deposit

Dr Cash

Cr Loss on future

contract

Cr Margin deposit

Dr Margin deposit

Cr Cash

Record payment of

initial margin deposit


Futures Contracts : illustration

• On March 1, 20X5, Company A speculates that the price of gold

will increase and purchases 10 gold futures contracts at a price of

$800/ounce. Each contract is for 100 ounces of gold and maturity

date is May 30. The futures exchange requires a payment of 10%

of notional amount as margin deposit. Following prices are given:

Example

Date Price/ounce May 30 futures

price/ounce

March 1 $798 $800

March 31 797 799

April 30 799 801

May 30 802 802

15


Futures Contracts: illustration (2)

Date Account Amount

March 1 Dr Margin Deposit

Cr Cash To record payment of margin deposit

80,000

80,000 10% x $800,000

March 31 Dr Loss on Futures Contract

Cr Futures Contract To record settlement or change in fair value

1,000

1,000 (800 - 799) x 100 x 10

April 30 Dr Futures Contract

Cr Gain on Futures Contract To record settlement or change in fair value

2,000

2,000 (801 - 799) x 100 x 10

May 30 Dr Cash

Dr Futures Contract

Cr Gain on Futures Contract

Cr Margin Deposit To record change in fair value and return of margin

Dr Gold

Cr Cash

Cr Futures Contract To record settlement and close futures contract

80,000

1,000

1,000

80,000 (802 - 801) x 100 x 10

802,000

800,000

2,000** **(802 - 800) x 100 x 10


Futures Contracts: illustration (3) Example

Date Account Amount

March 1 Dr Margin Deposit

Cr Cash To record payment of margin deposit

80,000

80,000 10% x $800,000

March 31 Dr Loss on Futures Contract

Cr Futures Contract To record settlement or change in fair value

1,000

1,000 (800 - 799) x 100 x 10

April 30 Dr Futures Contract


2,000

2,000 (801 - 799) x 100 x 10

May 30 Dr Futures Contract


Dr Gold

Cr Margin deposit

Cr Cash

Cr Futures Contract To close forward contract at maturity

1,000

1,000 (802 - 801) x 100 x 10

802,000

80,000

720,000

2,000** **(802 - 800) x 100 x 10

Alternative journal entries:

16


Hedging

• Propose is to neutralize an exposed risk

• Loss on hedge item offset by gain on hedging instrument

• Reduce volatility than preserve gains

• Other ways of hedging through non-derivative

derivatives

• Money market instruments (money market hedge)

• Natural hedge (offsetting foreign currency assets and

liability in the same currency)

• Special accounting rules called “hedge accounting”

applies when derivatives are used for hedging

purposes


Rationale of Hedge Accounting

• Arises because of the mismatch of income-

offsetting effect between hedged item and hedging

instrument

• Situations requiring hedge accounting:

• Hedge item and hedging instrument are measured using

different bases (One is at cost while the other is at fair

value)

• Hedged item yet to be recognized in financial statement

• Different treatment for changes in fair value (changes

taken to equity while the other is taken to income

statement)

17


Risks That Qualify for Hedge Accounting

Risks must be specific risk,

not general business risks

Possible for a derivative to

hedge more than one risk

Specific risks

that qualify for

hedge accounting

Interest rate risk

Foreign exchange risk

Price risk

Credit risk


Qualifying Hedging Instruments and

Hedged Items

• Instruments that qualify as hedging instruments include:

• Designated derivatives (except written options).

• Embedded Derivatives.

• Designated non-derivatives financial asset/ liability that hedge

foreign exchange risks only.

• Instruments that qualify as hedged items include:

• Financial assets and liabilities with exposure to changes in fair

value.

• Non-financial assets exposed to foreign exchange or price risks.

• Firm commitment.

• Highly probable forecast transaction with exposures to future cash

flows.

• Net investment in foreign entity.

18


Assessing Hedge Effectiveness

• During the duration of hedge, hedge effectiveness is

assessed on dollar-offset method:

• Hedge effectiveness ratio (HER):

Hedge effectiveness

(or delta ratio) =

Changes in fair value or future cash flow of hedging instrument

Changes in fair value or future cash flow of hedged item

0.8 1.25

Effective hedge


Classification of Hedging

Hedge of “the exposure to changes in fair value of a

recognized asset or liability or an unrecognized firm

commitment, or an identified portion of such asset, liability

or firm commitment, which is attributable to a particular

risk and could affect profit or loss”.

Fair value

hedge

Hedge of “the exposure to variability in cash flows that

(i) is attributable to a particular risk associated with a

recognized asset or liability (such as all or some future

interest payment on variable debt instrument )or a highly

probable future transaction, and

(ii) could affect profit or loss”.

Cash flow

hedge

Hedge of a net

investment in a

foreign entity

Hedge of the foreign currency risk associated with a

foreign operation whose financial statements are required

to be translated into the presentation currency of the

parent company.

19


Classification of Hedging (2)

• The designation of a derivative as a fair value

hedge or a cash flow hedge is determined by the

hedged risk, that is, whether the entity has a fair

value exposure or a cash flow exposure.

• An exception where a derivative can be designated

as either a fair value hedge or a cash flow hedge is

where the hedged risk is the foreign exchange risk

of a firm commitment.


Accounting for a Fair Value Hedge

Hedged Item (recognized asset

or liability or firm commitment) Hedging Instruments

Income statement

Gain (loss) on hedging instrument

offset loss (gain) on hedged item

Balance sheet

Change in fair value adjusted

against carrying amount

Change in fair value adjusted

against carrying amount

Change in fair value Change in fair value

20


Fair Value Hedge – Forward Contract Example

Date Spot Rate March 31 Forward Rate

Nov 1, 20X3 $352 $350

Dec 31, 20X3 342 340

March 31, 20X4 330 330

Ilustration: 31/10/20X3 • Inventory of 10,000 ounces of gold • Carried at cost of $3,000,000 ($300 per ounce) • Price of gold was $352 per ounce 1/11/20X3 • Sold forward contract on 10,000 ounce for forward price of

$350 ounce • Forward contract matures on 31/3/20X4


Fair Value Hedge – Forward Contract (2)

1/10/20X1

No entry or just a memorandum entry as the fair value of the forward

contract is nil

31/12/20X3

Dr Forward contract …………. 100,000

Cr Gain on forward contract ... 100,000

Gain on forward contract: 10,000 x ($340 -$350)

Dr Loss on inventory ………… 100,000

Cr Inventory ………………….. 100,000

Gain on forward contract: 10,000 x ($342 - $352)

Taken to income statement

Example

21



31/3/20X4

Inventory is sold to third-party at $330 per ounce (also maturity date of

forward contract

Dr Forward contract …………. 100,000

Cr Gain on forward contract ... 100,000

Gain on forward contract: 10,000 x ($330 -$340)

Dr Loss on inventory ………… 120,000

Cr Inventory ………………….. 120,000

Loss on forward contract: 10,000 x ($330 - $342)

Dr Cash ……………………….. 3,300,000

Cr Sales ………………………. 3,300,000

Sale of inventory: 10,000 x $330

Example



Dr Cost of Good Sold ……… 2,780,000

Cr Inventory ......................... 2,780,000

Cost of Good Sold: $3,000,000 - $100,000 - $120,000

Dr Cash ………….................. 200,000

Cr Forward Contract ……..... 200,000

Close forward contract and record net receipt on settlement:

10,000 x ($350 - $330)

31/3/20X4

Example

22



31/3/20X4

If inventory is NOT sold to third-party but SETTLED at maturity date

Dr Cash ………….................. 3,500,000

Cr

Cr

Forward Contract …….....

Inventory .......................

200,000

3,300,000

Close forward contract and record net receipt on settlement:

10,000 x ($350 - $330)

Dr Inventory …………. 520,000

Cr Gain on inventory ... 520,000

Gain on inventory at inception: 10,000 x ($352 -$300)

Example


Accounting for a Cash Flow Hedge

Effective Cash Flow Hedge

Effective portion

of gain/ loss

Ineffective portion

of gain/ loss

Recognized directly

in equity through

statement of

changes in equity

Recognized in profit

or loss

23


Assessing Effective Portion of Cash Flow

Hedge Example

Period

ending

Cumulative

∆ in FV of

future

contracts

(a)

Cumulative

∆ in PV of

expected

cash flow

(b)

Lesser of

two

cumulative

amount in

absolute

terms

(c)

Effective

portion

credited/

(debited)

to equity in

current

period*

Ineffective

portion

credited/

(debited)

to income

statement

in current

period**

31/1/20x1 $100 $(105) $100 $100 $0

28/2/20x1 190 (185) 185 85 5

31/3/20x1 293 (290) 290 105 (2)

30/4/20x1 255 (245) 245 (45) 7

* (c) - previous balance

**(a) - (c) - previous balance


Accounting for a Cash Flow Hedge (2)

Cash flow hedges are applicable to the following:

Forecasted

transactions

involving financial

and non-financial

assets/liabilities

which will result in

cash inflow/ outflow

Other transactions

which affect future

cash flows

Interest rate swaps

24


Cash Flow Hedge – Futures Contract Example

Date Spot Price/ounce March 31 Futures Price

Oct 1, 20X1 $3.30 $3.21

Dec 31, 20X1 3.265 3.17

Feb 28, 20X2 3.15 3.05

March 31, 20X2 3.10 3.00

Ilustration: 1/10/20X1 • Inventory of 5,000,000 ounces of silver. • Carried at cost of $15,000,000 ($3 per ounce). • Price of silver was $3.3 per ounce • Sold futures contract on 5,000,000 ounce for $3.21 /ounce. • Futures contract matures on 31/3/20X2. • Required margin deposit was $0.03 per ounce.


Cash Flow Hedge – Futures Contract (2)

Calculation of expected cash flows & fair value of futures contract

Example

25



Period-to-period & cumulative hedge effectiveness assessment

Example



Determination of effective and ineffective portions of a cash flow hedge

Period

ending

Cumulative

∆ in FV of

future

contracts

(a)

Cumulative

∆ in PV of

expected

cash flow

(b)

Lesser of

two

cumulative

amount in

absolute

terms

(c)

Effective

portion

credited/

(debited) to

equity in

current

period*

Ineffective

portion

credited/

(debited)

to income

statement

in current

period**

31/12/X1 200,000 (175,000) 175,000 175,000 25,000

28/2/X2 800,000 (750,000) 750,000 575,000 25,000

31/3/X2 1,050,000 (1,000,000) 1,000,000 250,000 0

* (c) - previous balance

**(a) - (c) - previous balance

Example

26



1/10/20X1

31/12/20X1

Dr Futures contract ………….. 200,000

Cr OCI – Hedge reserve ....... 175,000

Cr Gain on futures contract ... 25,000

Record fair value adjustment of futures contract

Dr Margin deposit …………. 150,000

Cr Cash ................................. 150,000

Margin deposit: $0.03 x 5,000,000 ounce

28/2/20X2



Cr Gain on futures contract ... 25,000


Example



31/3/20X2

Dr Cash ……………………….. 15,500,000

Cr Sales ………………………. 15,500,000

Sale of inventory: 5,000,000 x $3.1




Dr Cost of Good Sold ……… 15,000,000

Cr Inventory ......................... 15,000,000

Cost of Good Sold at carried cost

Dr OCI – Hedge reserve ....... 1,000,000

Cr Sales/ Cost of Good Sold .. 1,000,000

To ‘recycle’ hedging reserve against Profit & Loss

Example

27



Dr Cash ………….................. 1,200,000

Cr Margin deposit ................ 150,000

Cr Futures Contract ……...... 1,050,000

Close the futures contract and record receipt of margin

31/3/20X2

Example


Option Contracts

• Contract that gives holder the right but not the

obligation to buy or sell a specified item at a

specified price.

• 2 type of option contracts:

– Call option – right, but not obligation to buy.

– Put option – right, but not obligation to sell.

• Can be American option (exercisable anytime to

expiration) or European option (exercisable only on

maturity date).

• Can also be customized (not traded) or standard

contract quoted on exchange (listed options).

28


Option Contracts (2)

• Main features:

– Purchaser (holder) pays premium to seller (writer of option).

– Holder has the right, but not obligation to perform; while write has

obligation to perform.

– Asymmetrical pay-off profile:

• Holder has limited loss (due to premium) and unlimited gain.

• Writer has limited gain and unlimited loss.

Strike price>

Underlying

(spot price)

Strike price=

Underlying

(spot price)

Strike price>

Underlying

(spot price)

Holder of call

option

Out-of-the-money At-the-money In-the-money

Holder of put

option

In-the-money At-the-money Out-of-the-money


Option Contracts (3)

• Fair value of option contract

Fair value of an option = Intrinsic value + Time value

Call option = Max [0, Notional amount x (Spot price – Strike Price)

Put option = Max [0, Notional amount x (Strike price – Spot Price)

Diminishes over time

Zero at expiration

Listed options = quoted price

Not traded options = Valuation

model ( Black-Scholes model)

29


Purchased Option Contracts: Journal Entries


at expiration

Dr Option Contract

Cr Gain on future

contract

Dr Loss on futures

contract

Cr Option Contract

or

Adjust for fair value

and record gain/loss


net settlement of

contract

Dr Cash*

Cr Gain on option

contract

Cr Option Contract

Dr Cash*

Dr Loss on option

contract

Cr Option Contract

Dr Option contract

(asset)

Cr Cash

Record payment of


(* assume expires in-the-money. If out-of-

the –money, no cash entry is needed)


Written Option Contracts: Journal Entries


at expiration

Dr Option Contract

Cr Gain on future

contract

Dr Loss on futures

contract

Cr Option Contract

or

Adjust for fair value

and record gain/loss


net settlement of

contract

Dr Option contract

Cr Gain on Option

Contract

Dr Option contract

Dr Loss on option

Cr Cash

Dr Cash

Cr Option contract

(liability)

Record payment of


(Expires out-of-the-money)

(Expires in-the-money)

30


Call Option Contracts : illustration

• On March 1, 20X5, Company A purchased 100,000 unit of call

option of Company B with strike price of $35 and premium $4.5.

On that date, current market price of Company B stock was

$38/share. Company A settle the option on Aprill 30, 20X5 to

third party. Following prices are given:

Example

Date Stock Price Option Price

March 1 $38 $4.50

March 31 41 6.80

April 30 43 8.25

Date Option Price Intrinsic Value Time Value

March 1 $4.50 $3 $1.50

March 31 6.80 6 0.80

April 30 8.25 8 0.25


Call Option Contracts: Buyer

Date Account Amount

March 1 Dr Call Option

Cr Cash To record payment of premium

450,000

450,000 $4.5 x 100,000


Cr Gain on Option Contract To record change in intrinsic value

300,000

300,000 (6 – 3) x 100,000

March 31 Dr Loss on Option Contract

Cr Call Option To change in time value

70,000

70,000 (0.8 – 1.5) x 100,000

April 30

Dr Call Option


200,000

200,000 (8 – 6) x 100,000

April 30

Dr Loss on Option Contract

Cr Call Option To record change in time value

55,000

55,000 (0.25 – 0.8) x 100,000

Alternative: record the net amount

31



Date Account Amount

April 30 Dr Cash

Cr Call option To record settlement of option

825,000

825,000

Date Account Amount

Dr AFS

Dr Loss on Exercise of Option

Cr Call Option

Cr Cash To record the exercise and close option contract

4,300,000

25,000

825,000

3,500,000

• If company A exercise the option on Aprill 30, 20X5 :


Call Option Contracts: Writer

Date Account Amount

March 1 Dr Cash

Cr Call Option To record payment of premium

450,000

450,000 $4.5 x 100,000


Cr Call Option To record change in intrinsic value

300,000

300,000 (6 – 3) x 100,000


Cr Gain on Option Contract To record change in time value

70,000

70,000 (0.8 – 1.5) x 100,000

April 30


Cr Call Option To change in intrinsic value

200,000

200,000 (8 – 6) x 100,000

April 30

Dr Call Option


55,000

55,000 (0.25 – 0.8) x 100,000

32



Date Account Amount

Dr Cash

Dr Call Option

Cr AFS

Cr Gain on Exercise of Option To record the exercise and close option contract

3,500,000

825,000

4,300,000

25,000

• If company A exercise the option on Aprill 30, 20X5. Following

prices are given:


Put Option Contracts : illustration

• On March 1, 20X5, Company A purchased 100,000 unit of put

option of Company C with strike price of $35 and premium $2.5.

On that date, current market price of Company C stock was

$34/share. Company A settle the option on Aprill 30, 20X5 to

third party. Following prices are given:

Example


March 1 $34 $2.50

March 31 32 4.00

April 30 31 4.80


March 1 $2.50 $1 $1.50

March 31 4.00 3 1.00

April 30 4.80 4 0.80

33



Date Account Amount

March 1 Dr Put Option


250,000

250,000 $2.5 x 100,000



200,000

200,000 (3 – 1) x 100,000


Cr Put Option To record change in time value

50,000

50,000 (1.0 – 1.5) x 100,000

April 30

Dr Put Option


100,000

100,000 (4 – 3) x 100,000

April 30



20,000

20,000 (0.8 – 1.0) x 100,000



Date Account Amount

April 30 Dr Cash

Cr Put option To record settlement of option

480,000

480,000

Date Account Amount

Dr Cash

Dr Loss on Exercise of Option

Cr Put Option

Cr AFS To record the exercise and close option contract

3,500,000

80,000

480,000

3,100,000

• If company A already had Company C stock (assume: no hedge

relationship), and exercise the put option on Aprill 30, 20X5 :

34



Date Account Amount

March 1 Dr Cash

Cr Put Option To record payment of premium

250,000

250,000 $2.5 x 100,000


Cr Put Option To record change in intrinsic value

200,000

200,000 (3 – 1) x 100,000



50,000

50,000 (1.0 – 1.5) x 100,000

April 30


Cr Put Option To record change in intrinsic value

100,000

100,000 (4 – 3) x 100,000

April 30

Dr Put Option


20,000

20,000 (0.8 – 1.0) x 100,000



Date Account Amount

Dr AFS

Dr Put Option

Cr Cash

Cr Gain on Exercise of Option To record the exercise and close option contract

3,100,000

480,000

3,500,000

80,000

• If company A exercise the option on Aprill 30, 20X5. Following

prices are given:

35


Fair Value Hedge – Option Contract Example

• On March 1, 20X5, Company A purchased 100,000 of Company

D shares at $34/share.

• To ptotect itself against a loss in value of the investment,

Company A purchased 100,000 unit of put option of Company D

with strike price of $35 and premium $2.5 on the same date.

Company A settle the option on Aprill 30, 20X5 (maturity date).

Following prices are given:


March 1 $34 $2.50

March 31 32 3.80

April 30 31 4.00


Fair Value Hedge – Option Contract (2)


March 1 $2.50 $1 $1.50

March 31 3.80 3 0.80

April 30 4.00 4 0.00


March 1 $34 $2.50

March 31 32 3.80

April 30 31 4.00

36



Date Account Amount

March 1

Dr AFS


3,400,000

3,400,000 $34 x 100,000



250,000

250,000 $2.5 x 100,000



200,000

200,000 (3 – 1) x 100,000



70,000

70,000 (0.8 – 1.5) x 100,000

March 31

Dr Loss on Investment

Cr AFS To record change in fair value of AFS

200,000

200,000 (32 – 34) x 100,000

P/L



Date Account Amount

April 30

Dr Loss on Investment

Cr AFS To record change in fair value of AFS

100,000

100,000 (31 – 32) x 100,000

April 30 Dr Loss on Option Contract


80,000

80,000 (0 – 0.8) x 100,000

April 30

Dr Put Option


100,000

100,000 (4 – 3) x 100,000

April 30

Dr Cash

Cr Put Option

Cr AFS To record the exercise and close option contract

3,500,000

400,000

3,100,000

37


Swap

• In a swap, two counterparties agree to a

contractual arrangement wherein they agree to

exchange cash flows at periodic intervals.

• 2 type of basic swap:

– Single Currency Interest rate swap

• “Plain vanilla” fixed-for-floating swaps in one currency.

– Cross Currency Interest Rate Swap (Currency swap)

• Fixed for fixed rate debt service in two (or more)

currencies.


Swap (2)

• Interest Rate Swap:

– Used by companies and banks that require either fixed

or floating-rate debt.

– Interest rate swaps allow the companies (or banks) and

the swap bank to benefit by swapping fixed-for-floating

interest payments.

– Since principal is in the same currency and the same

amount, only interest payments are exchanged (net).

• Hedge using interest rate swap:

– Cash flow hedge changes in FV of swap are taken to

equity.

– Fair value hedge changes in FV of swap are taken to

P/L.

38


Swap (3)

Swap

Bank

Company A

prefers floating

Company B

prefers fixed

Pay fixed Pay floating

Receive

Floating

Receive

fixed

Issue floating Issue fixed

• Interest Rate Swap:


Cash Flow Hedge - Swap

• Cash flow hedge : Swap from floating to fixed rate.

– To protect future cash flow (interest) payments.

• Changes in fair value of swap are taken to equity.

• Interest payments are taken to P/L.

39


Cash Flow Hedge – Swap : Ilustration Example

• Company A had $10 million loan with interest at LIBOR + 50

basis points.

• To ptotect itself against an increase in interest rate, Company A

entered into swap contract with Company B on June 30, 20X5.

Under this contract, Company A paid interest at fixed rate of

7.75% on notional amount $10 million to Company B over 1 year

for the receipt of floating rate of LIBOR + 50 basis point. Interest

settlement were made at the end of each quarter. The rates are

as follows:

Date LIBOR LIBOR + 50 bp

June, 30 7.25% 7.75%

Sept, 30 6.25% 6.75%

Dec, 31 7.45% 7.95%

March, 31 7.50% 8.00%


Cash Flow Hedge – Swap : Ilustration (2)

Company A

prefers fixed

Company B

prefers floating

Pay

7.75%

Pay

LIBOR

+ 50 bp

Receive

LIBOR +

50 bp

Receive

7.75%

Issue fixed Issue LIBOR +

50 bp

• Assumption:

– Fair value of swap at inception is zero.

– Current floating rate continues to prevail till the end of

the swap tenure.

– FV swaps are discounted with LIBOR + 50 bp.

Example

40



Date Current

LIBOR

+ 50 bp

Receipt of

previous

LIBOR + 50

bp

(a)

Payment

of 7.75%

(b)

Current

net

receipt

(paid)

(c)

FV of

Swap

asset

(liability)

(d)

Change

in FV

(e)

June, 30 7.75% 0

Sept, 30 6.75% 193,750 193,750 0 (72,538) (72,538)

Dec, 31 7.95% 168,750 193,750 (25,000) 9,710 82,248

March, 31 8.00% 198,750 193,750 5,000 6,127 (3,583)

June, 30 200,000 193,750 6,250 0 (6,127)

(a) (previous LIBOR + 50 bp) x notional amount.

(b) 7.75% x notional amount.

(c) (a) – (b)

(d) PV of [ next period of (c) x number of next payments]

(e) Previous (e) + (d)

Example



Date Account Amount

Sept 30

Dr Interest Expense

Cr Cash To record payment of interest at floating rate

193,750

193,750

Sept 30

Dr FV adjustment (equity)

Cr Interest rate swap asset/liability To record fv adjustment

72,538

72,538

Dec 31 Dr Interest Expense


168,750

168,750

Dec 31 Dr Interest Expense

Cr Cash To record settlement of swap differential

25,000

25,000

Dec 31 Dr Interest rate swap asset/liability

Cr FV adjustment (equity) To record fv adjustment

82,248

82,248

Example

41



Date Account Amount

March 31

Dr Interest Expense


198,750

198,750

March 31 Dr Cash

Cr Interest Expense To record settlement of swap differential

5,000

5,000

March 31 Dr FV adjustment (equity)


3,583

3,583

June 30 Dr Interest Expense


200,000

200,000

June 30

Dr Cash

Cr Interest Expense To record settlement of swap differential

6,250

6,250

June 30 Dr FV adjustment (equity)


6,127

6,127


Fair Value Hedge - Swap

• Fair value hedge : Swap from fixed to floating rate:

– To protect from increase of value of debt.

– If market rate decreases, the value of fixed rate debt

increases.

• Changes in fair value of swap are taken to P/L.

• Even though the debt is carried at amortised cost

under PSAK 55, the carrying amount should be

adjusted by it’s fair value P/L.

• Changes in fair value of debt represent

discount/premium but not amortised as long as the

hedge is in place.

42


Sources:

• Tan & Lee – Advanced Financial Accounting.

• Lam & Lau – Intermediate Financial

Reporting 2nd Ed.

• Baker, Christensen, Cottrell – Advanced

Financial Accounting 10th Ed.

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