FINANCIAL INSTRUMENTS, DERIVATIVES AND HEDGE ACCOUNTING

FINANCIAL INSTRUMENTS, DERIVATIVES AND HEDGE ACCOUNTING BY UCHE UWALEKE PhD

Lecture Objective • 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

Presentation Outline • INTRODUCTION • MONEY MARKET INSTRUMENTS • CAPITAL MARKET INSTRUMENTS • FINANCIAL DERIVATIVES • HEDGE ACCOUNTING PRINCIPLES • CONCLUSIONS

INTRODUCTION Financial Instruments can be divided into two broad groups namely: • Money market instruments • Capital market instruments

MONEY MARKET INSTRUMENTS • 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.

Capital 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.

DERIVATIVES • 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

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

...Financial Derivatives-Participants • 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.

Hedge Accounting • 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- Fair Value • 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-Criteria • 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

...Hedged items • 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

...Hedging Instrument • 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

...Discontinuing Hedge Accounting Hedge accounting ceases when any of the following occurs: • A hedge fails an effectiveness test • Hedged item is sold or settled • Hedging instrument is sold, terminated or exercised

... Accounting Entries 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

Conclusions • 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.

THE END • Thanks for your attention

FINANCIAL INSTRUMENTS, DERIVATIVES AND HEDGE ACCOUNTING