Derivative financial instrument
- A derivative financial instrument derives its value from the value of some other financial asset or variable.
- Could be used for hedging or speculation purposes.
- Key aspects of derivatives:
- Contracts between buyers and sellers.
- Derivative value rises and falls in accordance with the value of the underlying asset.
- Payoff is often determined or made at the expiration date. Sometimes no money is exchanged at the beginning of the contract.
Examples of derivatives
- Forward contracts: currency, interest rates
- Options: currency, stock index, stocks and interest rates
- Future contracts: stock index, stocks, commodity
- Swaps: Currency, interest rates
Forward contracts vs futures contracts
- Both: a contract to buy or sell an agreed quantity of a particular item, at an agreed price, on a specific date.
- Forward: flexible, all terms can be negotiated with the counterparty.
- Not traded at securities exchange.
- Settlement occurs at end of contract, no margin calls or payments.
- High credit risk for each party.
- Futures: standardised. eg. 90 day bank bill futures, base amount $1m AUD, settled in around 90 days.
- Traded at securities exchange
- Initial margin and margin call
- Margin call: deposit a specific amount when entering contract.
- Exchange clearing house guarantees all trader in future market will honour their obligations.
- Calculate daily net positions of each trader
- Lower credit risk.
- Forward contracts
- Hedging is the process which offsets the potentially adverse risk exposure of the underlying position (the initial contract or event) by taking an opposite position to the underlying transaction.
- The second (offset) position aims to neutralise any potential change arising in the first/underlying position when rates of exchange change.
- Hedges may protect specific commitments, or be taken out subsequent to a credit transaction, or future forecast transactions – to protect the related monetary item.
- The hedge process manages the potential risk but at the same time it reduces the potential for gain.
- For entities that buy goods with the purchase price denominated in a foreign currency.
- Involves a situation where a third party (eg bank) agrees to sell a fixed amount of a particular overseas currency on a fixed future date at the rate of exchange quoted in the contract (the forward rate).
- Forward rate: The exchange rate that is currently offered for the future acquisition or sale of a specific currency
- For an entity that sells goods overseas with the sales price denominated in a foreign currency.
- An Australian entity can fix at the outset the amount of Australian dollars it will ultimately receive from a sale.
What is Hedge Accounting?
- Recognises the offsetting effects on profit or loss of changes in the fair values of the hedging instrument and the hedged item (AASB 139, par. 85).
- Attempts to match the timing of the profit or loss recognition on the hedging instrument with the profit and loss on the hedged item—only when the hedging instrument meets specific requirements.
- To classify an arrangement as a hedge and to apply ‘hedge accounting’ AASB 139 strictly requires five conditions to be met.
Hedged item: An asset (eg accounts receivable), liability (accounts payable), firm commitment, highly probable forecast transaction or net investment in a foreign operation that: (a) exposes the entity to risk in changes of fair value or future cash flows; and (b) is designated as being hedged.
- Hedging instrument: A designated derivative or (for a hedge of the risk of changes in foreign currency exchange rates only) a designated non-derivative financial asset or non-derivative financial liability whose fair value or cash flows are expected to offset changes in the fair value of cash flows of a designated hedge item.
- Examples include forward foreign currency exchange contracts and foreign currency swaps.
5 conditions to apply 'hedge accounting'
Note: cannot be designated as a hedge in terms of 'hedge accounting' retrospectively.
- 1. At the inception of the hedge there is a formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge
- 2. The hedge is expected to be highly effective in achieving offsetting changes in fair values or cash flows attributable to the hedge risk
- 3. 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 (foreign exchange changes on daily basis)
- 4. The effectiveness of the hedge can be reliably measured, i.e. the fair value or cash flows of the hedged item that are attributable to the hedged risk and the fair value of the hedging instrument can be reliably measured
- 5. The hedge is assessed on an ongoing basis and determined actually to have been highly effective throughout the reporting periods for which the hedge was designated (old standard)
: at the inception of hedge and throughout the life, the hedge must be highly effect. Changes in FV or cash flow must 'almost fully' offset the changes in the FV f hedging instrument.
Effectiveness of hedge: old standard
- Hedge is deemed to be highly effective so that the actual results are in a range of between 80 and 125%.
- Eg. If there is a gain on a hedging instrument of $100 and the loss on the hedged item is $110 the effectiveness of the hedge in terms of offsetting the loss on the hedged item is 100/110 (90.01%)—if the loss on the hedge item was $200 the test would not have been met.
Effectiveness test: new standard
- The 80-125% threshold has been removed.
- Retrospective hedge effectiveness test not required,
- A lot less onerous and complex.
- Effect: If, at the end of a reporting period, the hedge was only 70% effective, the entity would recognise 30% of ineffectiveness in P/L but would not discontinue hedge accounting. (VS Discontinue of hedge accounting under AASB 139 if not within the 80—125% range!!)
- New hedge effectiveness tests under AASB 9:
- 1. existence of an economic relationship: expect hedged item and hedging instrument to offset fair value
- 2. Credit risk is not a significant driver of the fair value changes of hedged item or hedging instrument.
- Apply the same hedge ratio for risk management purposes.
- Hedge ratio: the relationship between the quantity of the hedging instrument and the quantity of the hedged item in terms of their relative weighting.
Cash flow hedge
Cash-flow hedges: A hedge of the exposure to variability in cash flows that (i) is attributable to a particular risk associated with a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction and (ii) could affect profit or loss.
Treatment of gains/losses on hedging
- For a cash flow hedge that is an effective hedge:
- For hedged item: (AR/AP) The gain or loss on the hedged item at fair value is to be treated as part of the period’s profit or loss.
- For hedging instrument: (forward contract) Until the point where the inventory changes hands, and the purchase or sale of inventory is recorded, any gains or losses on the hedging instrument is initially recognised in equity, and therefore included in other comprehensive income.
Is the hedge effective?
A highly probable forecast transaction: The forward contract is entered into at the time the order is made, and it is highly likely to continue.
Formal designation and documentation of the hedging relationship.
At inception the hedged instrument is for 100% of the hedged item (US$3 million of order and US$3 million of forward contract).
The transaction meets the criteria to apply ‘hedge’ accounting (Expect to be highly effective at inception).
We will test for retrospective hedge effectiveness at balance date (as per current standard).