FINANCIAL INSTRUMENTS, DERIVATIVES AND HEDGE

ACCOUNTING

BYUCHE UWALEKE PhD

Understand key financial instruments

Learn how derivatives could be used as Hedging instruments

Be familiar with the main requirements of IFRS 9 with regard to Hedge Accounting

Lecture Objective

INTRODUCTIONMONEY MARKET INSTRUMENTSCAPITAL MARKET INSTRUMENTSFINANCIAL DERIVATIVESHEDGE ACCOUNTING PRINCIPLESCONCLUSIONS

Presentation Outline

Financial Instruments can be divided into two broad groups namely:

Money market instrumentsCapital market instruments

INTRODUCTION

Treasury Bills (TBs)- short term borrowing instruments of the fed issued through the central bank.

Certificate of Deposits (CDs)- promissory note issued by a bank in form of a certificate entitling the bearer to receive interest.

MONEY MARKET INSTRUMENTS

Commercial Papers (CPs)- short term unsecured promissory note issued by large companies and financial institutions at a discounted value on face value.

Banker’s Acceptance (BAs)- a bill of exchange drawn by a person and accepted by a bank. A buyer’s promise to pay to the seller a certain specified amount at certain date guaranteed by the banker of the buyer.

.... Money market Instruments

Repurchase Agreements (Repos)- transactions or short-term loans in which two parties agree to sell and repurchase the same security.

...Money market Instruments

Common Stock/Equities/Ordinary shares- certificates are legal documents that evidence ownership in a company

Preferred Stock/Shares enjoy prior claims over the ordinary shareholders and carry a fixed rate of dividend.

Capital Market Instruments

Debentures and Bonds- Interest bearing debt instrument.

Convertibles- Securities that can be converted to ordinary shares.

...Capital Market Instruments

Derivatives refer to a broad class of instruments which derive their value from the price of the underlying asset.

In the case of commodity derivatives, underlying asset can be wheat, gold, oil etc.

For financial derivatives, it can be stock, currency etc.

The focus of this section is on financial derivatives

DERIVATIVES

Forward Contract- An agreement between two parties to buy or sell an asset in future. The price which is paid/received by the parties is decided at the time of entering into the contract.

See Illustration

Financial Derivatives

Futures- a standardized forward contract to buy or sell the underlying asset at a specified price in the future through an organized Exchange.

There are margin requirements to provide safeguard.

See illustration

...Financial Derivatives

Options Contract- An option is a right but not the obligation to buy or sell something at a stated date and specified price.

A call option gives one the right to buy; a put option the right to sell.

See Illustration

...Financial Derivative

Swap Contract- an agreement between parties, called counterparties, to exchange streams of cash flows over a period of time in the future

...Financial Derivatives

Hedgers- use derivatives to reduce the risk associated with the price of an asset.

Speculators- bet on future movements in the price of an asset with a view to making profit.

Arbitrageurs- take advantage of a discrepancy between prices of the same asset in different markets.

...Financial Derivatives-Participants

IAS 39 and IFRS 9 deal with all financial assets and liabilities including derivatives.

The basic principle is that all derivatives are carried at fair value with gains and losses captured in the income statement.

Hedge Accounting

The fair value of a financial asset or liability is the amount for which the financial asset could be exchanged or the financial liability settled between knowledgeable, willing parties in an arm’s length transaction.

Underlying this concept of fair value is the presumption that an entity is a going concern

...Hedge Accounting- Fair Value

The item being hedged must be identified and designated at the inception of the hedge.

The hedging instrument must be identified and designated at the inception of the hedge.

...Hedge Accounting-Criteria

The effectiveness of the hedge must be tested regularly throughout its life.

Effectiveness must fall within a range of 80% - 125% over the life of the hedge

...Hedge Accounting-Criteria

The hedged item can be an asset or liability and must expose the entity to risk of changes in fair value.

These risks include equity price risk, foreign currency risk, interest rate risk etc

...Hedged items

Most derivative financial instruments may be designated as hedging instruments provided they are with an external party.

An entity’s own equity instruments do not qualify

...Hedging Instrument

Hedge accounting ceases when any of the following occurs:

A hedge fails an effectiveness test

Hedged item is sold or settledHedging instrument is sold, terminated or exercised

...Discontinuing Hedge Accounting

Three types of Hedge Accounting are recognized by IFRS 9

Fair value Hedge Cash flow Hedge Net Investment in a foreign operation

See illustrations for specific accounting treatment of these hedging relationships

... Accounting Entries

Financial instruments are either short term or medium to long term known as money or capital market instruments respectively.

Financial derivatives can be used as hedging instruments.

The basic principle of IFRS 9 is that all derivatives are carried at fair value with gains and losses recognized in the income statement in the period in which they arise.

Conclusions

Thanks for your attention

THE END