1. Derivatives Marco Venuti 1

2. Financial derivatives These are characterised by an underlying element, which may be the price or rate of an asset or of a liability but not the asset or liability itself (interest rates, currency exchange rates, share prices, other commodity prices, price indexes…) A derivative usually has a notional amount, which is an amount of currency, a number of shares, a number of units of weight or volume or other units specified in the contract. However, a derivative instrument does not require the holder or writer to invest or receive the notional amount at the inception of the contract 2

3. IAS 39 – paragraph 9 A derivative is a financial instrument or other contract within the scope of this Standard (see paragraphs 2–7) with all three 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, provided in the case of a non- financial variable that the variable is not specific to a party to the contract (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. 3

4. Financial derivatives - continued Swaps. These are a contractual agreement to exchange or swap assets or payment obligations or currencies Options. These give the purchaser the right, but not the obligation, to buy (call option) or sell (put option) a specific quantity of a financial instrument, commodity or other assets Forwards. These are fixed payments or payments of an amount that can change as a result of some future event Futures caps and floors. These are contracts resembling interest rate options Credit derivatives. These are contracts used to hedge against credit risks 4

5. Interest rate swaps IRSs are commonly used to hedge interest rate risk. They permit changes in the interest risk profile of interest bearing assets and/or liabilities. Corporations usually enter into a swap to transform the interest basis of a debt obligation from a floating to a fixed rate or vice versa. The two counterparties to a swap agree to exchange, at certain future dates, two sets of cash flows denominated in the same currency. 5

6. Interest rate swap - example Start date15 January 2010 CounterpartiesCompany ABC and DEF Bank Maturity3 years (15 January 2013) NotionalEur 100 million ABC pays5% semiannualy. Actual 30/ 360 basis ABC receives Euribor 12 – month, annualy, actual/360 basis, Euribor is fixed two days prior to the beginning of the annual interest period 6

7. Interest rate swap 15 Jan x15 Jul x15Jan x +115 Jul x +115 Jan x+215 Jul x+215 Jan x+3 5% Fixed leg 15 Jan x15Jan x +115 Jan x+215 Jan x+3 2,7%Euribor 12m Floating leg 7

8. Interest rate swap The fixed leg of this swap has six interest periods and the floating leg three periods. ABC will be paying Eur 2,5 million ((100.000.000* 5%)/2) every 15 of July and every 15 of January during the life of the swap The floating leg cash flows are unknown at the beginning of the swap (except the first one). ABC expects to receive Eur 2.737,5 (2,7%*100.000.000* (365/360))on the 15 January 2011. 8

9. Interest rate swap – accounting implications the swap is often linked to a specific liability the market value of the swap and the liability are usually determined using different yield curves (one curve that incorporates issuers credit spread for liability market value and the other curve that excludes this credit spread for IRS) the evaluation of the swap is at fair value the evaluation of the liability is at fair value too, even if the classification procedure puts this liability in the amortised cost compartment it should be noted that the interest rate sensitivities of a liability and its related interest swap can be significantly different. 9

10. Embedded derivatives An embedded derivative is a component of a hybrid (combined) instrument that also includes a non- derivative host contractwith the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative. A derivative that is attached to a financial instrument but is contractually transferable independently of that instrument, or has a different counterparty from that instrument, is not an embedded derivative, but a separate financial instrument 10

11. Embedded derivatives An embedded derivative shall be separated from the host contract and accounted for as a derivative if, and only if (par.11): (a) the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host contract; (b) a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and (c) the hybrid (combined) instrument is not measured at fair value with changes in fair value recognised in profit or loss (ie a derivative that is embedded in a financial asset or financial liability at fair value through profit or loss is not separated). Examples: A put option embedded in an instrument that enables the holder to require the issuer to reacquire the instrument for an amount of cash or other assets that varies on the basis of the change in an equity or commodity price or index is not closely related to a host debt instrument Equity-indexed interest or principal payments embedded in a host debt instrument or insurance contractby which the amount of interest or principal is indexed to the value of equity instrumentsare not closely related to the host instrument because the risks inherent in the host and the embedded derivative are dissimilar 11