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ACCOUNTING FOR DERIVATIVES

ACCOUNTING FOR DERIVATIVES. PURPOSE OF USING DERIVATIVES. The ultimate motivation for using derivatives is to manage or reduce financial risks. TYPES OF FINANCIAL RISKS. Price Risk Foreign Currency Risk Interest Rate Risk Credit Risk. WHAT IS A DERIVATIVE?.

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ACCOUNTING FOR DERIVATIVES

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  1. ACCOUNTING FOR DERIVATIVES

  2. PURPOSE OF USING DERIVATIVES The ultimate motivation for using derivatives is to manage or reduce financial risks.

  3. TYPES OF FINANCIAL RISKS • Price Risk • Foreign Currency Risk • Interest Rate Risk • Credit Risk

  4. WHAT IS A DERIVATIVE? A derivative is simply a financial instrument that derives its value from the movement in commodity price, foreign exchange rate and interest rate of an underlying asset or financial instrument.

  5. CHARACTERISTICS OF A DERIVATIVE • The value of the derivative changes in response to the change in an “underlying” variable. • The derivative requires either no initial net investment or a little initial net investment. • The derivative is readily settled at a future date.

  6. BASIC TYPES OF DERIVATIVES • Options • Forwards • Futures • Swaps

  7. OPTIONS An option is contract that gives the holder the right to purchase or sell an asset at a specified price during a definite period at some future time.

  8. FORWARDS A forward contract is a commitment to purchase or sell a specified commodity on a future date at a specified price

  9. FUTURES Futures are obligations to buy or sell a specific commodity on a specific day for a preset price.

  10. FORWARDS versus FUTURES

  11. SWAPS An agreement made by two parties to exchange a series of cash flows in the future.

  12. INTEREST RATE SWAPS Interest rate swaps constitute a contractual agreement between two parties to exchange cash flows at periodic intervals based on a hypothetical principal.

  13. HEDGE ACCOUNTING • Fair Value Hedge Cash Flow Hedge

  14. Fair value – Something is already “locked in” and you need to protect it Cash flow – You are “locking in” something MAJOR TYPES OF HEDGES Fair value hedge is a protection against risk caused by fixed terms, rates or prices. Cash flow hedge is a protection against risk caused by variable terms, rates or prices.

  15. Fair Value Hedge

  16. Fair Value Hedges • A hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment (or portion of such asset, liability or firm commitment) attributable to a particular risk • The gain or loss from remeasuring the hedging instrument is recognized immediately in P&L • Gain or loss on the hedged item attributable to the hedged risk adjusts the carrying amount of hedged item and is recognized immediately in P&L

  17. Cash Flow Hedge

  18. Cash Flow Hedge A hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with a recognized asset or liability or a highly probable forecasted transaction that will affect future reported profit or loss

  19. Accounting for Cash Flow Hedges • The hedging instrument is carried at fair value • Accounting treatment of gains and losses: • The effective portion of the gain or loss on the hedging instrument is recognized in equity and subsequently recognized in earnings in the same period or periods the hedged forecasted transaction affects earnings

  20. THANK YOU!

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