CHAPTER 4: DERIVATIVES AND HEDGING TRANSACTIONS

Definition of a derivative
A derivative is a financial instrument or other contract that derives its value from the changes in value of some other
underlying asset or other instrument.

Characteristics of a derivative
1. its value changes in response to the change in an underlying;
2. requires no initial net investment or a very minimal initial net investment; and
3. it is settled at a future date.

Common types of derivatives

1. Forward contract – is an agreement between two parties to exchange a specified amount of a commodity,
security, or foreign currency at a specified date in the future at a pre-agreed price.
2. Futures contract – is 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.

Forwards Futures
 Private contracts which are most likely over the  Traded in a market
counter transactions.
 Customized contracts  Standardized contracts
 Private contracts between two private parties who  A party in a futures contract may never know the
interact directly with each other other contracting party because they interact
indirectly through a broker.
 May be settled by the actual delivery of the  Normally settled through net cash payment.
agreed-upon commodity or net cash payment.

3. Option – is a contract giving the holder the right, but not the obligation, to buy or sell an asset at a specified price
any time during a specified period in the future. When the holder exercises his right, the writer of the option is
obligated to perform his obligation on the option contract.

Types of options as to right of holder:

a. Call option – an option to buy.
b. Put option – an option to sell

 At the money – holder may or may not exercise option, no gain or loss in exercising.
 In the money – holder should exercise, gain in exercising.
 Out of the money – holder should not exercise, loss in exercising.

4. Swap – is a contract in which two parties agree to exchange payments in the future based on the movement of
some agreed-upon price or rate. Common examples include:
a. Interest rate swap – is a contract between two parties who agree to exchange future interest payments on
a given loan amount. Usually, one set of interest payments in based on a fixed interest rate and the other
is based on a variable interest rate.
b. Foreign currency swap – is a contract between two parties who agree to exchange sum of money in one
currency for another currency.
5. Caps, floors and collars – are essentially 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
rate.
6. Swaption – is an option on a swap. The option provides the holder with the right to enter into a swap at a
specified future date at specified terms. This derivative has characteristics of an option and a swap.
7. Weather derivative – a contract that requires payment based on climatic, geological or other physical variables.

Measurement
All derivatives are measured at fair value. The accounting for fair value changes depends on whether the derivative is:
 CHAPTER 4: DERIVATIVES AND HEDGING TRANSACTIONS
1. Not designated as a hedging instrument;
2. Designated as fair value hedge; or
3. Designated as cash flow hedge.

No hedging designation (held for speculation)

Derivatives not designated as hedging instrument are accounted for as held for trading securities. Accordingly, fair value
changes are recognized in profit or loss (i.e., FVPL).

EMBEDDED DERIVATIVES
 Contract outside the scope of IFRS 9
 Financial liability

Contract outside the scope of IFRS 9 at the same time it is a financial liability.
1. Economic characteristics not closely related.
2. Separate instrument would meet the definition of derivative.
3. Hybrid instrument not at FVTPL

*Bifurcation – process of separating the embedded derivative form the host contract.

 Financial asset – don’t separate. Apply the measurement rules to the entire hybrid contract.

Purpose of derivatives
1. to speculate (incur risk); or
2. to hedge (avoid or manage risk) – to minimize risk.

Financial risk – the risk of possible future change in one or more of a specified interest rate, financial instrument 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.

Subdivided into:
1. Credit risk – the risk that one party to a financial instrument will cause a financial loss for the other party by failing
to discharge an obligation.
2. Liquidity risk – the risk that an entity will encounter difficulty in meeting obligations associated with financial
liabilities that are settled by delivering cash or another financial asset.
3. Market risk – the risk that the fair value or future cash flows of a financial instrument will fluctuate because of
changes in market prices. It comprises three types of risk:
a. Currency risk – the risk that the fair value or future cash flows of a financial instrument will fluctuate
because of changes in foreign exchange rates.
b. Interest rate risk – the risk that the fair value or future cash flows of a financial instrument will fluctuate
because of changes in market interest rates.
c. Other price risk – the risk that the fair value or future cash flows of a financial instrument will fluctuate
because of changes in market prices (other than those arising from interest rate risk or currency risk),
whether those changes are caused by factors specific to the individual financial instrument or its issuer or
by factors affecting all similar financial instruments traded in the market.

HEDGE ACCOUNTING
This is to represent, in the financial statements, the effect of an entity’s risk management activities that use financial
instruments to manage exposures arising from particular risks that could affect profit or loss or OCI, the case of
investments in equity instruments for which an entity has elected to present changes in fair value in OCI.

 The premise here is about offsetting.

Hedging
Hedging means designating one or more hedging instruments so that their change in fair values or cash flows offset, in
whole or in part, the change in the fair value or cash flows of the hedged item.

Components of a hedging relationship

Hedging instrument – a designated derivative or a designated non-derivative financial asset or financial liability whose fair
value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item.
 CHAPTER 4: DERIVATIVES AND HEDGING TRANSACTIONS
Hedged item – an asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign
operation that (a) exposes the entity to risk of changes in fair value or future cash flows and (b) is designated as being
hedged.

Hedged items
A hedged item can be a:
1. Recognized asset or liability (e.g., recorded receivables or recorded payables)
2. Unrecognized firm commitment (e.g., receivable not yet recorded on a future sale commitment or payable not yet
recorded on a future purchase commitment)
3. Highly probable forecast transaction (e.g., a planned but not committed future sale or future purchase; the “girly
stuff” you want to purchase)
4. Net investment in a foreign operation (e.g., a foreign subsidiary)

 Firm commitment – is a binding agreement for the exchange of a specified quantity of resources at a specified
price on a specified future date or dates.
 Forecast transaction – is an uncommitted but anticipated future transaction.
 Foreign operation – is an entity that is a subsidiary, associate, joint venture or branch of a reporting entity whose
activities are based or conducted in a country or currency other than those of the reporting entity.
 Net investment in a foreign operation – is the amount of the reporting entity’s interest in the net assets of that
operation.

Qualification for hedge accounting

1. The hedging relationship consists only of eligible hedging instruments.
2. At the inception of the hedging relationship there is a formal designation and documentation of the hedging
relationship and the entity’s risk management objective and strategy for undertaking the hedge.
3. The hedging relationship meets all the hedge effectiveness requirements.

Hedge effectiveness requirements:

1. There is an economic relationship between the hedged item and the hedging instrument.
2. The effect of credit risk doesn’t dominate the value changes that result from that economic relationship.
3. The hedge ratio of the hedging relationship is the same as that resulting from the quantity of the hedged item that
the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that
quantity of hedged item.

Designation of hedging instruments

As a rule: a qualifying instrument must be designated in its entirety as a hedging instrument.

Exception:
1. Separating the intrinsic value and time value of an option contract and designating as the hedging instrument only
the change in intrinsic value of an option.
2. Separating the forward element and the spot element of a forward contract and designating as the hedging
instrument only the change in the value of the spot element of a forward contract; similarly, the foreign currency
basis spread may be separated and excluded from the designation of a financial instrument as the hedging
instrument.
3. A proportion of the entire hedging instrument such as 50% of the nominal amount.

Designation of hedged items

As a rule: An entity may designate an item in its entirety or a component of an item as the hedged item in a hedging
relationship.

Can be designated:
1. Only changes in the cash flows or fair value of an item attributable to a specific risks or risks (risk component).
2. One or more selected contractual cash flows.
3. Components of a nominal amount (i.e. a specified part of the amount of an item.)

Hedging relationships
Hedging relationships are of three types:
1. Fair value hedge – hedge of the exposure to changes in fair value of a recognized asset or liability or a previously
unrecognized firm commitment or an identified portion of such an asset, liability or firm commitment that is
attributable to a particular risk and could affect profit or loss.
 CHAPTER 4: DERIVATIVES AND HEDGING TRANSACTIONS
2. Cash flow hedge – hedge of the exposure to variability in cash flows that is attributable to a particular risk
associated with a recognized asset or liability (such as all or some future interest payments on variable rate debt)
or a highly probably forecast transaction and could affect profit or loss.
3. Hedge of a net investment in a foreign operation – accounted similarly to cash flow hedge. Amount of the
reporting entity’s interest in the net asset of the operation.

Type of hedge Accounting for changes in fair values of hedging

instrument (derivative)
1. No hedging designation (speculation) Profit or loss
2. Fair value hedge Profit or loss
3. If the hedging instrument hedges an equity Other comprehensive income
instrument designated as fair value through other
comprehensive income
4. Cash flow hedge:
a. Effective portion Other comprehensive income
b. Ineffective portion Profit or loss
5. Hedge of a net investment in a foreign operation:
a. Effective portion Other comprehensive income
b. Ineffiective portion Profit or loss

Type of hedged item Type of hedge

1. Recognized asset or liability Fair value hedge or cash flow hedge
2. Unrecognized firm commitment By default, Fair value hedge. (except for a hedge of the
foreign currency risk of a firm commitment which may
be accounted for as a fair value hedge or a cash flow
hedge.
3. Highly probable forecast transaction Cash flow hedge
4. Net investment in foreign operation Cash flow hedge
5. Fixed to variable (floating) Fair value hedge
6. Variable (floating) to fixed Cash flow hedge

PROBLEM 1
On October 31, 2024, Bakilan Co. acquired machinery that costs from a foreign entity HK$120,000 and is payable in one
year’s time. Its operating currency is Philippine peso, and the current exchange rate is P1: HK$.125. on October 31, 2024,
it entered into a forward contract to acquire HK$120,000 in one year’s time at the current exchange rate.
Determine the following:
1. Hedged item
2. Hedged risk
3. Hedging instrument
4. Transaction date
5. Settlement date
6. Notional amount
7. Notional amount of the HK$120,000

PROBLEM 2
On January 1, 2023, Surigao paid ₱17,000 cash to acquire a call foreign currency option for 1,000,000 Thailand Baht, with
an expiration date of December 31, 2023, the firm’s fiscal year ends June 30. Direct spot and strike price are as follows:
1/1/2023 6/30/2023 12/31/2023
Spot rate (market price) ₱1.15 ₱1.18 ₱1.17
Strike price (exercise price) ₱1.14 ₱1.14 ₱1.14
Fair value of call option ₱44,000
1. What is the intrinsic value and time value of option on January 1, 2023?
2. What is the intrinsic value and time value of option on June 30, 2023?
3. What is the intrinsic value and time value of option on December 31, 2023?
4. How much did it save by purchasing the call option?
5. Prepare the journal entries from January 1, 2023, through December 31, 2023.

PROBLEM 3
 CHAPTER 4: DERIVATIVES AND HEDGING TRANSACTIONS
Makiling Co. purchased equipment from USA for $100,000 on December 16, 2024, with payment due on February 14,
2025. On December 16, 2024, it also acquired a 60-day forward contract to purchase dollars on February 14, 2025. The
direct spot and forward rates were:
Spot rate Forward rate
Selling Buying 60-day 45-day 30-day
12/16/2024 ₱43.00 ₱42.00 ₱43.50 ₱44.50 ₱43.00
12/31/2024 ₱45.00 ₱44.00 ₱43.00 ₱46.00 ₱45.50
2/14/2025 ₱45.50 ₱44.50 ₱42.50 ₱46.50 ₱44.00

1. Prepare the journal entries to record the purchase of equipment, all entries associated with the forward contract,
the adjusting entries on December 31, 2024 and entry to record the payment on February 14, 2025.
2. What was the effect on the income statement of the foreign currency transactions, including both the accounts
payable and the forward contract for the year ended December 31, 2024?
3. What was the overall effect on the income statement of these transactions from December 16, 2024 through
February 14, 2024?

PROBLEM 4
Saldivar Co. sold electrical equipment to a US Co, for $10,000 on May 15, 2024, with collections due in 60 days. On the
same day, it entered into a forward contract to sell $10,000 on July 15, 2024. Its fiscal year ends on June 30. The direct
spot and forward rates follow:
5/15/2024 6/30/2024 7/25/2024
Buying spot ₱49.50 ₱48.00 ₱47.00
Selling spot ₱51.50 ₱50.00 ₱49.00
Buying forward – 15 days ₱47.00 ₱47.30 ₱45.00
Selling forward – 15 days ₱49.00 ₱49.30 ₱43.00
Buying forward – 30 days ₱47.50 ₱46.00 ₱47.00
Selling forward – 30 days ₱48.30 ₱47.00 ₱45.50
Buying forward – 45 days ₱48.00 ₱47.50 ₱48.50
Selling forward – 45 days ₱49.50 ₱46.40 ₱47.20
Buying forward – 60 days ₱48.50 ₱49.00 ₱48.00
Selling forward – 60 days ₱51.50 ₱50.20 ₱47.60
1. Prepare all required journal entries to record the above transactions.
2. What was the effect on the income statement on June 30?
3. What was the overall effect on the income statement for these transactions?

PROBLEM 5
Catanduanes Co. purchased merchandise for $10,000 from a foreign vendor on December 1, 2024. Payment in dollar is
due February 28, 2025. On December 1, 2024, it signed an agreement with a foreign exchange broker to buy $10,000 on
February 28, 2025. Exchange rates to purchase $1 are as follows:
Spot rate Forward rate
12/01/2024 ₱45 ₱40
12/31/2024 ₱44 ₱35
2/28/2025 ₱47 ₱47
Fiscal year end is 12/31; Discount rate = 12%
1. Prepare all required journal entries to record the above transactions.
2. What was the effect on the income statement on December 31?
3. What was the overall effect on the income statement for these transactions?

PROBLEM 6
Marimar Co. suggested that the company speculate in foreign currency as a partial hedge against its operations. On
October 1, 2024, it bought 180-day forward contract to purchase ¥5,000,000 at a forward rate of ¥1 = ₱.75 when the spot
rate was ₱ .70. other exchange rates were as follows:
Date Spot rate Forward rate for
3/31/2025
12/31/2024 ₱.73 ₱.76
3/31/2025 ₱.72

Required: Prepare all journal entries using net position related to Marimar Co’s foreign currency speculation from October
1, 2024, through March 31, assuming the fiscal year ends on December 31, 2024.

PROBLEM 7
 CHAPTER 4: DERIVATIVES AND HEDGING TRANSACTIONS
On November 2, 2024, Tenorio Co. entered into a firm commitment with a Japanese supplier to purchase a machine,
delivery and passage of title on March 31, 2025, at a price of ¥ 2,600,000. On the same date, to hedge against
unfavorable changes in the exchange rate of the yen, it entered into a 150-day forward contract with Metro Bank for
¥2,600,000. The relevant exchange rates were as follows:
11/02/2024 12/31/2024 3/31/2025
Bid spot rate ₱.4020 ₱.4250 ₱.3840
Offer spot rate ₱.4140 ₱.4370 ₱.3965
Bid forward rate ₱.4325 ₱.4170 ₱.3840
Offer forward rate ₱.4450 ₱.4295 ₱.3965

Required: Prepare all journal entries related to Tenorio Co’s foreign currency denominated purchase commitment from
November 2, 2024, through March 31, 2025, assuming the fiscal year ends on December 31, 2024 and the forward
contract is classified as a:
Case No. 1: Fair value hedge
Case No. 2: Cash flow hedge

PROBLEM 8
On December 31, 2024, Detuya, a Philippine firm estimates or forecasted the purchase of 5,000 units of inventory from
Taiwan. The purchase would probably occur on January 2025 and require the payment of 500,000 Nt dollars. The
transaction is highly probable, and it is to be denominated in Nt dollar. It is anticipated that the inventory could be further
processed and delivered to customers within six months. Detuya Co. enters into a forward contract to purchase 500,000
Nt dollars on January 31, 2025 for P1.01. On June 30, 2025, the inventory sold for P625,000 after further processing cost.
Spot and froward rates at the January 31, 2025 settlement were as follows (pesos per Nt dollar):
Spot rate Forward rate
December 1, 2024 ₱1.03 ₱1.01
December 31, 2024 ₱1.00 ₱0.99
January 31, 2025 ₱0.98 ₱0.98

The fiscal year ends on December 31, 2024.

Required: Prepare all journal entries related to its hedge of forecasted transactions from December 1, 2024 through June
30, 2025 using perpetual inventory system, assuming the exchange differential is accounted as basis adjustment under
IFRS 9.

PROBLEM 9
On December 31, 2024, Indoy Company, the parent of the 100% owned Japanese subsidiary expected the yen to weaken
by the end of 2025. Accordingly, the parent contracted with a foreign exchange trader on December 31, 2024, to sell
2,300,000 yens (the subsidiary’s net asset position at that date) in 365 days at the forward rate of ₱.435. the following
direct exchange rates are as follows:
12/31/2024 12/31/2025
Spot rate ₱.440 ₱.400
Forward rate (selling forward) ₱.435 ₱.400
The January 1, 2025, balance of the translation reserve (cumulative) – debit amounted to ₱129,000 and translation
reserve loss for 2025 of ₱100,000. The December 31, 2025 foreign exchange gain or loss on forward contract.