FINANCIAL DERIVATIVES (FD) PAPER PRESENTATION BY AHMAD ABUBAKAR

DEFINITION A Derivative is a Financial Instrument or other contract whose value is derived from the performance of the underlying financial Asset; e.g. Interest rates, currency exchange rate or stock market indices. It requires no initial net investment. It is settled at a future date. Derivative securities are neither debt nor equity and derive their values from an underlying asset that is often another security e.g. Options, Forwards and Futures.

INITIAL MEASUREMENT All Derivatives are recognized in the Statement of Financial Position as either financial assets or liabilities. They are initially measured at fair value. The direct external transaction costs are recognized in profit or loss

SUBSEQUENT MEASUREMENT IFRS requires subsequent measurement of all Derivatives at fair value, regardless of any hedge relationship that might exist. Changes in fair value are recognized in P or L as they arise unless they qualify for hedge accounting.

TYPES OF DERIVATIVES Basically, there are four types of Financial Derivatives – Forward Option Futures Swap

FORWARD CONTRACT It is an agreement to buy or sell an asset at a predetermined price and at a specified future time. One of the parties to a forward contract agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party agrees to sell the underlying asset on the same date and price. e. g. currency forward The buyer is said to have a “long position” while the seller has a “short position”

SWAP CONTRACT A Swap is an agreement between two counter parties to exchange a series of payments over a specified period of time, based on reference rate (interest rate, currencies, indices or commodities) applied to a notional amount. e.g. Interest Rate Swap: paying fixed rate and receiving floating rate, paying floating rate and receiving fixed rate. Currency Swap: Exchange 2 million U. S. Dollars for 1 million Pound-Sterling in each of the next five years.

FUTURES CONTRACT A futures contract, like a forward contract, is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. While the details of a forward contract are negotiated between the parties to the contract, futures contracts are normally traded on an organized or regulated Exchange where traders used to assemble periodically on the floor of the Exchange to buy and sell these contracts generally by open outcry.

FUTUTES CONTRACT Futures contracts are standardized agreements to exchange specific types of goods, in a specific amounts and at specific future dates. Commodities and Financial Assets form the underlying assets in Futures contracts e.g. wheat, sugar, gold, stocks, bonds and foreign currencies or stock indices.

OPTION CONTRACT An Option contract is one that gives the holder the right, but not the obligation, to buy or sell specified quantity of the underlying asset at a specific price (the exercise price) for a specified period of time (expiration date). The development of organized Options exchanges has created markets where these options, as securities, are traded. These basic form of Options are – Rights, Warrants and Calls & Puts.

CALL-OPTION A call option is an option to purchase a specified number of shares of stock on or before a specified future date at a stated price (striking price). It has initial period of 1-9 months, occasionally 1yr. The striking price is the price at which the holder can the stock at any time prior to the option’s expiration date.

CALL-OPTION This price is generally set at or near the prevailing market price of the stock at the time of issuing the option. To purchase a call option, a specified price of, normally, a few thousands Naira must be paid.

CALL-OPTION e. g. – Assuming Mr. Ahmad pays N2,500 for a 3-months call-option of 1000 units @ N50 on Opara Enterprises, a maker of Aircraft Components. It means that by paying N2,500, Mr. Ahmad is guaranteed that he can purchase 1000 shares of Opara Enterprise at N50/share at any time during the next 3 months. This stock price climb N2.50 per share to N52.50/share to cover the cost of the option

CALL-OPTION If stock price were to rise to N60/share during the period, Ahmad’s net profit would be N7,500 {(60 *1000) – (50 * 1000) – 2,500}. Had the stock price not risen above N50/share, Ahmad would have lost the N2,500 because there would have no reason to exercise the option.

PUT-OPTION A Put-option gives the holder the right, but not the obligation, to sell an underlying security, e.g. share stock, at a specific price for a specified time. Holders of Puts commonly own share stocks and wish to protect the gain they have realized since their initial purchase. Put-option locks the gain by enabling them sell the shares at a known price during the life of the option. Investors gain from Put-option when the price of the underlying stock declines by more than the per share cost of the option.

OPTIONS An option will only be exercised by the holder if the option is “in money”. The option will be “in money to the holder if: For a call-option – the mkt price of the underlying asset is greater than the exercise price. For a Put-option – the mkt price of the underlying asset is less than the exercise price.

EMBEDDED DERIVATIVES Embedded Derivative is a derivative that is included in a non-derivative contract, called the host contract. It causes some or all the cash-flows, that otherwise would be required by the contract, to be modified according to a specified interest rate, foreign exchange rate, price of a financial instrument, e.t.c.

EMBEDDED DERIVATIVES Examples of Hybrid Financial Instruments with embedded option are Callable Bonds, Puttable Bonds and Convertible Bonds. The economic characteristics and risks of an embedded derivative are not closely related to the host contract and thus, an entity is expected to account for the embedded derivative separately from the host contract. A Derivative embedded in an Insurance contract (host) is closely related to the host if the derivative and the host are so interdependent that an entity cannot measure the derivative separately without considering the host contract.

EMBEDDED DERIVATIVE Embedded Derivative should be separated from host contract and accounted for as a derivative if: 1. Host contract is not measured at FVTPL 2. It would be a derivative on stand alone 3. Not closely related to the host contract

HEDGING Hedging is making an investment or acquiring some derivative or non-derivative instruments in order to offset potential losses (or gain) that may be incurred on some items as a result of a particular risk. Example: Company that operates in USD has receivables in 9 months from Europe that would be paid in EUR. The company is afraid that due to fluctuation in foreign currency rates, it may get less USD after 9 months and therefore enters offsetting foreign currency forward contract with a bank to sell the EUR for some fixed rate after 9 months.

HEDGING In our example above: Hedged Risk – Foreign Currency Risk Hedged Item – Receivable in foreign currency Hedging Instrument – Foreign Currency Forward Contract to sell EUR for a fixed rate at a fixed date.

HEDGING An investor who holds a portfolio of Securities may be anxious about the possibility that the prices of shares might fall. He thus faces a risk of reduction in the value of his portfolio on account of an adverse movement of shares prices in the stock market. He can effectively hedge this risk by taking a position in the stock index futures that will provide him a gain in the event of a fall in share prices.

HEDGING If he anticipates a fall in share prices, he should take a ‘short position’ (or sell) in the required number of stock index futures. He would thus be guaranteeing a selling price for sale of the stock index for a specific period in the future. If there is fall in the share prices in the future as anticipated, the stock index would also fall correspondingly.

HEDGING The investor can then close out his position in the index futures by taking a ‘long position’ (or buying) in the same number of contracts. The buying price would be lower than his predetermined selling price. The reduction in the value of his portfolio would be compensated by the gain in the index futures transaction without making any change in his original portfolio of shares.

HEDGE ACCOUNTING Hedge Accounting attempts to match the timing of profit or loss recognition on the derivative with that of the item being hedged if specific hedge accounting criteria are met. Key steps to achieving hedge accounting are: Identify the nature of the risk being hedged Identify the hedged item or transaction Identify the hedging instrument Document the hedging relationship above, including the risk management objectives, strategy for undertaking the hedge

HEDGE ACCOUNTING This is where an entity designs one or more hedging instruments so that their change in fair value offsets the change in fair value or the change in cash-flows of a hedged item. Without hedge accounting - any gain or loss resulting from the change in fair value of the hedging instrument would be recognized directly to P or L. With hedge accounting – the hedge would be accounted for as cash-flow or fair value hedge. You recognize gain or loss from hedging instrument directly to equity (OIC).

WHY HEDGE ACCOUNTING? Hedge accounting is optional; so you can select not to follow it and recognize all gains or losses from your hedging instruments to profit or loss. However, with hedge accounting, your Income Statement is less volatile because you basically match these gains or losses with gains or losses on your hedged item. It allows losses on a hedged item to be offset against gains on a hedging instrument. Also, you disclose to the readers of your FS that: Your company faces certain risks You perform certain risk management strategies in order to mitigate those risks How effective these strategies are.

CONDITIONS FOR HEDGE ACCOUNTING Hedge accounting is permitted provided that the hedging relationship is clearly defined, measurable and effective. The Conditions for Hedge Accounting include the followings: 1. Formal designation and documentation of the hedging relationship, entity’s risk management objectives and the strategy for undertaking the hedge. It is expected to be highly effective in achieving offsetting changes in fair value or cash-flows attributable to the hedged item.

CONDITIONS FOR HEDGE ACCOUNTING The effectiveness of the hedge can be reliably measured. The effectiveness is assessed on an ongoing basis throughout the reporting period. For cash-flow hedges, a forecast transaction that is the subject of the hedge must be highly probable and must present an exposure to variations in cash-flows that could ultimately affect profit or loss.

ASSESSING HEDGE EFFECTIVENESS A hedge is highly effective only if the following conditions are met: At inception and subsequently, the hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designated. Actual results of the hedge are within a range of 80% - 125% e.g. loss on hedging instrument is N120 and the gain on the hedged item is N100, offset can be measured by N120/N100 which is 120%, or by N100/N120 which is 83% (all within the range, thus the hedge is effective). Effectiveness is to be assessed at the time of preparation of FS (Interim or Annual).

WHEN HEDGE ACCOUNTING IS DISCONTINUED. Hedge Accounting must be discontinued, prospectively when: The hedged instrument is sold, expires or terminated/exercised The hedge no longer meets the effectiveness criteria. The forecast transaction that is a subject to a cash flow hedge is no longer highly probable. The entity revokes the designation.

TYPES OF HEDGING RELATIONSHIP AND ACCOUNTING TREAMENT There are 3 types of hedging relationships and accounting treatment: 1. Fair Value Hedge 2. Cash Flow Hedge 3. Hedge of Net Investment

FAIR VALUE HEDGE It is a hedge of the exposure to changes in fair value of a recognized asset or liability or unrecognized firm commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss. Fair Value Hedge is practically hedging Fixed Item; you are worried that, in the future, you would be paying or receiving a different amount than the market or fair value.

ACCOUNTING TREATMENT Step 1: Determine the fair value of both hedged item and the hedging instrument at the reporting date. Step 2: Recognize any change in fair value on the hedging instrument in profit or loss. Step 3: Adjust Carrying Amount of the hedged item through profit or loss for the gain or loss on the hedged item attributable to the hedged risk. This applies even if the hedged item is an AFS Financial Asset measured at fair value with changes in fair value recognized in OCI. It also applies if the hedged item is otherwise measured at cost. – IFRS 9 and IAS 39

CASH FLOW HEDGE It is a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all or a component of a recognized asset or liability or a highly probable forecast transaction, and could affect profit or loss. – IFRS 9 and IAS 39 It is a hedge against the risk of changes in cash flows of a recognized asset or liability or a highly probable forecast transaction attributable to a risk that could affect profit or loss. e.g. Interest rate Swap to change floating rate debt to fixed rate debt.

ACCOUNTING TREATMENT Assuming your cash flow hedge meets all hedge accounting criteria, you may need to take the following steps: 1. Determine the gain or loss on your hedging instrument and the hedged item at the reporting date. 2. Calculate the effective and ineffective portions of the gain or loss on the hedging instrument. 3. Recognize the effective portion of the gain or loss on the hedging instrument in OCI under ‘Cash flow Hedge Reserve’ 4. Recognize the ineffective portion of the gain or loss on the hedging instrument in profit or loss. 5. Deal with the cash flow hedge reserve when necessary i.e. when the hedged cash flows affect profit or loss, or when a hedged forecast transaction occurs.

ACCOUNTING TREATMENT If a hedge of a forecast transaction subsequently results in the recognition of a financial asset or a financial liability, the associated gains/losses recognized in OCI should be reclassified from equity to profit or loss in the same period or periods during which the hedged forecast cash flows affect profit or loss e.g. periods when interest income or expense is recognized.

ACCOUNTING TREATMENT If a hedge of forecast transaction subsequently results in the recognition of a non-financial asset/liability, then you can either: 1. Reclassify the associated gains/losses recognized in OCI to profit or loss in the same period during which the asset acquired or liability assumed affects profit or loss (e.g. when depreciation or cost of sales is recognized in profit or loss); or 2. Remove the associated gains/losses recognized in OCI and include them in the initial cost or other carrying amount of the asset or liability.

ACCOUNTING TREATMENT For cash flow hedges other than those covered above, amounts recognized in OCI should be reclassified from equity to profit or loss in the same period during which the hedged forecast cash flows affect profit or loss i.e. when the forecast sale occurs.

HEDGE OF NET INVESTMENT IN FOREIGN OPERATION FOREIGN CURRENCY HEDGES: Foreign Currency Hedges need to meet the following criteria to qualify for Hedge Accounting: 1. The hedged item must be denominated in a currency other than the entity’s functional currency; or 2. The hedge relationship is a hedge of a net investment in a foreign operation as defined in IAS 21.

FOREIGN CURRENCY HEDGES Examples: 1. Fair Value Hedge – a forward foreign exchange contract used to hedge the foreign currency exposure on an available-for-sale equity instrument. 2. Cash Flow Hedge – a forward foreign exchange contract used to hedge the currency exposure of an operating lease denominated in another currency. 3. Cash Flow Hedge – a forward foreign exchange contract entered into to hedge a highly probable forecast sales transaction in a foreign currency.

FOREIGN CURRENCY CASH FLOW HEDGES Examples of Foreign Currency Cash Flow Hedges include the followings: 1. Anticipated sales hedged with a forward contract 2. Anticipated intercompany sales hedged with a forward contract. 3. Anticipated sales hedged with an option contract.

ACCOUNTING TREATMENT Hedge accounting for the hedge of a net investment in a foreign operation is accounted for in a similar manner to cash flow hedge. Fundamentally, IAS 39 embraces the traditional process of matching foreign currency gains or losses on a derivative or liability against the revaluation of a foreign operation, based on period end exchange rates. The gain or loss on the hedging instrument is recorded in equity to offset the translation gains and losses on the net investment, to the extent that the hedge is highly effective. The ineffective portion is recognized in profit or loss.