2. Teaching Methodology
Focus on understanding the business objectives of a session
Interactive, using case studies and questions
Attendee active participation as learning among professionals is the
key to mastering a topic
2.00
2
3. 2.00
3
• Cliff Beacham - Please call me Cliff
CPA, Chartered Accountant (SA), CGMA, MBA,
MCDBA
• I have travelled around the world quite a bit
• - visited 63 countries
• Microsoft Certified Trainer and Senior Accounting
Lecturer at University of Natal in the early 80’s
• History of senior management positions at a wide
variety of companies in CFO, Controller roles and
other financial management positions
Course Instructor
4. Contents
1. Basics - Recognition
2. Business Models for Accounting for Financial Instruments
3. Derivatives
3a. Definition & Characteristics of derivatives
1) Value changes
2) No initial investment
3) Settled at a future date
3b. Notional amount, underlying & non-financial variables
3c. Common derivatives
3d. Derivatives in substance
3e. Hybrid instruments (Embedded derivatives)
2.00
4
5. A thought – aggregation
Apart from splitting an instrument into its components parts
they can be aggregated together
B4.1.10
Group
of
Financial
Instruments
FUND
Derivative
2.00
5
6. 1. Basic Recognition
This is a difficult task for a company
Practical solution:
- a checklist may simplify decisions and
- facilitate implementation of policies
6
7. Initial Recognition
B4.1.10
An entity can recognise regular way purchases or sales using trade
date or settlement date accounting
The general rule applies to forward contracts and futures unless
they meet the definition of executory contracts
The general rule applies to options, swaps and collars
The general rule is to recognise a financial asset or a financial
liability when the entity becomes a party to the contractual
provisions of the instrument
The entity only recognises a firm commitment when:
At least one of the parties has performed under the contract or
The contract becomes an onerous contract or
The contract becomes a designated hedged item
7
8. Initial Recognition
B4.1.10
Accounted for only if :
1. objectively measured using an active market (Level 1) or
2. based on a valuation technique which uses only observable
markers (Level 2)
Cost has long been the valuation criterion – in the context of a
free market and between knowledgeable and willing buyers
and sellers
The quoted price in an active market is taken as the best
context for price = value
Since it is possible to make a Profit or a Loss on Day 1 we must
think about where to show this
8
9. Initial Recognition B4.1.10
Consolidate
Which part of
the asset (or
group of assets)
should
derecognition
principles should
be applied to
Are the rights to
the cash flows
expired?
Has the entity
transferred its
rights to receive
cash flow from
the assets ?
Has the entity
transferred
substantially the
risks & rewards?
Has the entity
reliquished
control of the
asset?
Derecognise
Has the entity
assumed an
obligation to pay
out the cash
flows from the
assets ?
Continue
Continue
This is actually a Derecognition slide – but I want you to look at it here
9
10. IFRS 9 - Recognition
2.01
In addition, IFRS 9 states that a modification of the
terms of a financial asset may lead to its derecognition
IFRS 9.3
IFRS 9.B5.5.25–26
IFRS 9.5.4.4, B3.2.16(r)
IFRS 9 incorporates without substantive amendments the
requirements of IAS 39 for the recognition and
derecognition of financial assets and financial liabilities
However, IFRS 9 includes new guidance on write-offs of
financial assets – clarifying that a write-off constitutes a
derecognition event for a financial asset or a portion
thereof, and explaining when an asset (or a portion) should
be written off
10
11. Recognising Contracts
An entity recognises all of its
contractual rights and obligations under derivatives
in its Statement of Financial Position
as Assets and Liabilities, respectively
If a transfer of a financial asset does not qualify for
derecognition, the transferee does not
recognise the transferred asset as its asset (see
paragraph B3.2.15)2.01
(B3.2.14)
Derivatives that prevent a transfer of financial assets
from being accounted for as a sale are excluded
(B3.2.14).
11
12. Examples:
Recognising Contracts (1)
Unconditional receivables and payables
are recognised as assets or liabilities
when the entity becomes a party to the contract and,
as a consequence,
has a legal right to receive or
a legal obligation to pay cash.
2.01
(B3.1.2)
12
13. Examples:
Recognising Contracts (2)
2.01
(B3.1.2)
Assets to be acquired and liabilities to be incurred
as a result of a firm commitment to purchase or sell
goods or services
are generally not recognised until at least one of the
parties has performed under the agreement
An entity that receives a firm order does not generally
recognise an asset (and the entity that places the order
does not recognise a liability) at the time of the
commitment but, rather,
delays recognition until the ordered goods or services
have been shipped, delivered or rendered 13
14. Examples:
Recognising Contracts (3)
If a firm commitment
to buy or sell non-financial items
is within the scope of this Standard in accordance with
paragraphs 5–7 of IAS 39,
its net fair value is recognised as an asset or a liability on
the commitment date
2.01
(B4.1.30(c)
14
15. Examples:
Recognising Contracts(4)
If a previously unrecognised firm commitment is
designated as a hedged item in a fair value hedge,
any change in the net FV attributable to the hedged risk
is recognised as an asset or a liability
after the inception of the hedge
2.01
6.5.8(b)
6.5.9
15
16. Examples:
Recognising Contracts (5)
6.5.8(b)
6.5.9
If the net fair value of the right and obligation is not zero,
the contract is recognised as an asset or liability.
A forward contract that is within the scope of IFRS 9.2.1
is recognised as an asset or a liability
on the commitment date
rather than on the date on which settlement takes place.
When an entity becomes a party to a forward contract,
the FV of the right and the obligation are often equal,
so the net FV of the forward = 0
16
17. Examples:
Recognising Contracts (6)
Option contracts that are within the scope of this IFRS
9.2.1 are recognised as assets or liabilities when
the holder or writer becomes a party to the contract.
2.01
6.5.8(b)
6.5.9
17
18. Examples:
Recognising Contracts (7)
Planned future transactions, no matter how likely, are
not assets and liabilities
because the entity has not become a party to a contract
2.01
6.5.8(b)
6.5.9
18
19. Examples:
Regular way Purchases (1)
A regular way purchase or sale of financial assets is
recognised using either
trade date accounting or
settlement date accounting
as described in paragraphs B3.1.5 and B3.1.6.
2.01
IFRS 9.B3.1.5 & 6
19
20. IAS 39 – Regular way Purchase or Sale
Trade date is the date that an entity commits itself to
purchase or sell an asset.
Trade date accounting refers to
(a) the recognition of an asset to be received and the
liability to pay for it on the trade date, and
(b) derecognition of an asset that is sold, recognition of any
gain or loss on disposal and the recognition of a receivable
from the buyer for payment on the trade date
Generally, interest does not start to accrue on the asset and
corresponding liability until the settlement date when title
passes.
B3.1.4&5
20
21. IAS 39 – Regular way Purchase or Sale
Settlement date is the date that an asset is delivered
Settlement date accounting refers to
(a) the recognition of an asset on the day it is received
(b) the derecognition of an asset and recognition of any gain
or loss on disposal on the day that it is delivered by the
entity.
Any change in the fair value of the asset to be received
during the period between the trade date and the
settlement date in the same way as it accounts for the
acquired asset
B3.1.6
21
22. Examples:
Net Transactions(1)
A contract that requires or permits
net settlement of the change in the value of the contract
is not a regular way contract.
Instead, such a contract is accounted for as a derivative
in the period between the trade date and the settlement
date.
2.01
IFRS 9.B3.1.4
22
23. IFRS 9 –
FV at Settlement date
2.01
In addition, IFRS 9 states that a modification of the
terms of a financial asset may lead to its derecognition
A change in FV of the asset to be received during the period
between the trade date and the settlement date is
accounted for in the same way as for the acquired asset
i.e. the change in fair value is:
– not recognised for assets measured at amortised cost;
– recognised in profit or loss for assets measured at FV_PoL;
– recognised in OCI for assets measured at FV_OCI.
23
24. Designation
Example: Designation of a group of assets
B4.1.33-36
A group of financial liabilities or financial assets and
financial liabilities is managed and its performance is
evaluated on a fair value basis
The focus in this instance is:
on the way the entity manages and evaluates
performance, rather than on the nature of its financial
instruments.
24
28. We have to get this out of the way
Definitions
28
29. IAS 39 – Derivative (1)
A derivative is a financial Instrument with all 3 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’);
29
30. IAS 39 – Derivative (2)
A derivative is a financial Instrument with all 3 of the
following characteristics:
(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
30
31. Derivatives instruments
Derivatives are risk transference contracts
Their value is based on 1 or more underlying market factors
- events (EG defaults and bankruptcies),
- reference rates (EG interest rates and foreign exchange rates),
- prices of assets, (EG commodities, bonds, and equities)
Derivatives instruments include:
Forwards
Futures
Swaps
options
31
32. Derivatives instruments
- Forwards
Forwards are bilateral contracts that specify the terms of an
exchange at a future date
Forwards typically have no upfront costs or fees, making
it possible for market participants to enter positions
without incurring immediate costs
32
33. Derivatives instruments
- Futures
Futures are standardized forward contracts that are traded on
exchanges and centrally cleared by CCPs
Futures contracts, like forward contracts, call for an exchange at
a future date, but the terms of the contract (other than price
and quantity) are established as standard terms for all traders
by the exchange.
33
34. Derivatives instruments
- Swaps
Swaps are derivatives contracts that set out the terms of a
series of forward transactions
Typically, a swap transaction involves an exchange of cash flows
based on the notional amount at specified intervals (or “reset”
dates) during the life of the swap
Some swaps, however, call for an exchange or payment of the
full notional amount
Generally, swaps are structured so that at inception, the value
of the swap is zero
Swaps may be traded and cleared either bilaterally or through
central market infrastructures 34
35. Derivatives instruments
- Options
Options are derivatives contracts that give the holder of the
contract the right but not the obligation to purchase or sell the
underlying interest at a specific date or time interval in
accordance with the terms of the contract
The buyer of an option pays a premium for the right to exercise
the option (buying/selling the underlying interest) in the future
The seller of an option receives the premium in return for
agreeing to buy or sell the underlying interest to the option
holder at the agreed price if the holder exercises the option
Options are traded both in listed markets and over-the-counter
35
36. Derivatives Market
participants
Derivatives can be used by market participants to:
- achieve a desired risk exposure,
- to speculate in the markets,
- to reduce transaction costs, or
- to avoid certain regulatory costs
Market participants can be classified as
hedgers,
speculators, or
a combination of the two.
36
37. Hedgers seek to transfer or
manage risk exposures
An airline may wish to lock in the price of fuel over a certain time
horizon so that it can accurately forecast its cost basis and offer
airline tickets for sale months in advance.
It may do so by hedging in the energy derivatives market.
There are limited opportunities to hedge jet fuel using jet fuel
futures.
Airlines may hedge with a mix of crude oil, heating oil, and
unleaded gasoline futures calibrated to closely correlate with
the volatility in the jet fuel prices or use customized swaps.
37
38. Speculators enter into derivatives
contracts purely seeking profit.
Some speculators benefit from the leverage that is associated with
derivatives contracts—as a result, the profit or loss can be large in
comparison to the initial cost of entering into a trade
Others may benefit from lower transaction costs or from
regulatory or tax arbitrage.
Speculators are important because they contribute to market
liquidity. Hedgers benefit from this liquidity.
The line between the hedgers and speculators can be blurred,
as some market participants alternate between taking
speculative positions and hedging risk.
38
39. 1 Cash-settled forward Contract (1)
An electrical equipment manufacturer (buyer) would like to
lock in a price of copper and enters into a copper price forward
with a swap dealer that will settle 3 months from today
Cash-settled forward – example OTC forward:
The transaction is a forward copper purchase of a hypothetical
(notional) quantity of 1,000 metric tons at an agreed forward
price of $6,000 per ton
If, on the settlement date, the market price of copper is, say,
$6,500 per ton, the buyer will pay $6,500,000 for copper at the
market price
39
40. 1 Cash-settled forward Contract (2)
Cash-settled forward – example OTC forward:
At the same time, the dealer will pay the buyer $500,000
($6,500 - $6,000 on 1,000 tons).
The buyers net outflow of $6,000,000 ($6,000 per ton)
But suppose the price of copper on the settlement date were
$5,200 per metric ton
In this case, the buyer pays $5,200,000 for the copper, but pays
the swap dealer $800,000
$5,200 - $6,000 per ton—on the forward.
Again, the effective price is $6,000
40
Notice - this contract refers to the price of copper but
does not involve delivery of copper
41. 2 Physical Settlement Forward Contract
Physical settlement
But it also could have involved physical settlement, that is,
actual delivery of the copper against payment.
If the forward were physically settled, the buyer would agree to
pay $6,000,000 to the copper dealer, and the dealer would
agree to delivery of 1,000 metric tons of copper to the buyer on
the settlement date
Again, regardless of which way the price moves, the buyer
would lock in the price of $6,000 per ton
41
42. 3 Call option (1)
Re: above example –
Assume the manufacturer (buyer) decided
to buy a call option on 1,000 tons of copper from the swap
dealer, with expiration 3 months from today
Example: Call option
The terms of the option are as follows:
1. the strike price is $6,000/ton - the buyer will have the right
(but not the obligation) to buy copper at the strike price
2. option can be exercised in 3mths
3. option premium is $150/ton, so the buyer pays the dealer
$150,000 today
42
43. 3 Call option (2)
Suppose that, 3mths later, price of copper is $6,500 /ton
so the option is in-the-money
The buyer would exercise the option;
dealer would pay the client the $500/ton
(current price of $6,500 - strike price of $6,000) effectively,
the price is capped at $6,000 (ignoring the premium).
But suppose the market price on the exercise date = $5,200
In this case, the option would be out-of-the-money,
so the buyer would not exercise the option to buy
but would benefit anyway
by buying copper at the lower market price
43
44. 4 Forward vs Call Option
A forward contract - the buyer locks in a price of copper:
- If the price rises > forward price, the dealer pays the buyer
- if the price falls < forward price, the customer pays the dealer
the buyer has locked in the forward price
- transferring its price risk to the dealer
An option, in contrast,
1. protects the buyer from a rising price
2. allowed the buyer to benefit from a fall in the price
However, this asymmetry comes at a price:
an option always requires the buyer to pay a premium
(the price of the option) to the seller
44
46. IAS 39 – Derivative (1)
A derivative is a financial Instrument
with all 3 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’)
46
47. IAS 39 – Derivative (2)
A derivative is a financial Instrument
with all 3 of the following characteristics:
(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.
47
50. Derivatives
– The Long and the Short
B4.1.33-36
The long side of a transaction is
the risk/hope to the Buyer that
the price will increase
Buyer
Seller thinks
price will go
down
Goes Short
= sells
The short side of a transaction is the risk
that the Seller avoids that the price will
decrease (they avoid a loss)
Seller Transaction
Buyer thinks
price will go up
Goes Long
= buys
50
51. Derivatives – Risk Underwriting
B4.1.33-36
Financial Instruments that transfer risks
If you held a future on 1m Barrels of Oil would you sell?
If yes, are you going Short on Oil?
Going Short means you think the price of oil will decrease
If you are offered a future on 1m Barrels of Oil would you buy?
If yes, are you going Long on Oil?
Going Long means you think the price of oil will increase
51
52. 1st Characteristic of Derivative:
Causes of Change in Value of Derivative
1. Change in Notional
2. Change in Underlying variable
3. Change in Non-financial variable
Change in Value can be due to:
52
53. 1. Notional of a derivative Amount
A derivative usually has a notional amount which is
expressed as:
a) An amount of currency or
b) Number of shares or units
but does not require the holder to receive the notional
amount at inception
53
55. Example:
Notional Of a derivative Amount
Company XYZ places an order in France for delivery
in 6mths time at € 2m and
enters into a hedge contract at $1.65
No matter what the contract says
the notional amount is still €2m
55
56. 2. Underlyings
Appendix A
1. Specified interest rate (LIBOR)
This list is from the standard (but there are more that are not listed)
A derivative will always have an underlying variable
2. Financial Instrument price (Share price)
3. Commodity price (Price of 1 barrel of oil)
4. Foreign exchange rate (Spot rate)
5. Indexes (CPI)
6. Credit rating (Fitch)
7. Credit index (Corporate Bond Index – AAA)
8. Non-finance variable (Earthquake index)
56
57. 3. Non-financial variable (1)
These are usually specific to only one of the parties to the
contract but does not have to be specific to either
Example:
Earthquake index and weather variables are Non-
financial derivatives
IFRS 9.BA.5
57
58. 3. Non-financial variable (2)
These are usually specific to only one of the parties to the
contract but does not have to be specific to either
Example:
A punter pays a Bookie (bets) that a horse will win a race
– the underlying is the result of the race
– a variable which is actually not specific to either party
Such contracts are defined as non-financial derivatives
IFRIC July 2007
However the standard is unclear on these definitions 58
60. 2nd Characteristic of Derivative:
Nil Initial Investment
Actually this does not mean Nil but an amount less than the
Notional Value of the investment
Example [IAS39.AG11]:
An option contract meets that definition because the
premium is less than the investment that would be required
to obtain the underlying financial instrument to which the
option is linked
60
61. 2nd Characteristic of Derivative:
Nil Initial Investment
IAS39 AG11
One of the defining characteristics of a derivative is that it
has 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.
Example:
A currency swap that requires an initial exchange of
different currencies of equal fair values meets the definition
because it has a zero initial net investment.
61
62. 3rd Characteristic of Derivative:
Settled at future date
This is sort-of self-explanatory
62
63. Common Derivatives
Examples
IFRS 9.8.32
Type of Contract Underlying
Interest Rate Swap
Currency Swap
Interest Rate
Exchange rate
Commodity Swap Commodity price
Credit Swap Credit rating
Bond Option (Call or Put) Interest rates
Stock Option (Call or Put) Equity prices (another)
Currency futures Exchange rates
Currency forwards Exchange rates
Commodity Forwards Commodity price
63
64. In-substance Derivatives
Implementation Guidance
IFRS 9.B.6
Non-derivative transactions should be aggregated
(and treated as a derivative) when:
They are entered into at the same time (in
contemplation of one another)
They have a common counter-party
They relate to the same risk
There is no reason not to treat them as a single
transaction
64
65. IAS 39 – Embedded derivative
A component of a hybrid (combined) contract
that also includes a non-derivative host contract—
with the effect that some of the cash flows of the combined
contract vary in a way similar to a stand-alone derivative
It causes some or all of the cash flows to be modified
according to 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 65
66. IAS 39 – Embedded derivative (cont)
A derivative that is attached to a financial instrument
but is:
1. contractually transferable independently of that
instrument, or
2. has a different counterparty from that instrument,
is not an embedded derivative,
but a separate financial instrument
66
67. The Market for Derivatives
Let us look at the market for derivatives as
some background information
67
68. Trading on the exchange
Login to the exchange
Set Risk Limit (Buy Order)
[Trader]
Set Risk Limit (Buy Order)
[Broker]
Prep Buy Order
Drop copies
Settlement
Heartbeat – is established
[Trader – Exchange]
Risk manager checks
Risk manager confirms
limit is noted
Order to matching engine
Order acknowledged
Order fulfilled
Copy to Broker
Settlement data CH-Broker
ExchangeTrader
68
69. Derivatives Market
The derivatives market is the market for financial
instruments like futures contracts or options,
which are derived from other forms of assets
The market can be divided into 2,
1. that for exchange-traded derivatives and
2. that for over-the-counter derivatives
The legal nature of these products is very different,
as well as the way they are traded
69
74. Largest Dealer Banks (2012)
Bank of America
Merrill Lynch
Barclays
BNP Paribas
Citigroup
Credit Suisse
Deutsche Bank
Goldman Sachs
HSBC
JP Morgan Chase
Morgan Stanley
Nomura
Societe Generale
Royal Bank of Scotland
UBS
Wells Fargo
74
75. Federal Reserve System (1)
75
The US Fed is an independent financial institution and can
be described as the place where the US does its banking.
There are 12 regional Federal Reserve Banks that have
‘members’ whose interests are not proprietary
The U.S. Federal Reserve System or the “Fed”
(of which the twelve regional Federal Reserve banks are a part)
was created by an Act of Congress in 1913 in a response to a
series of economic crises at the turn of the early 20th century.
76. Federal Reserve System (2)
Its purpose was to establishing an effective supervisory role of
banking systems in the United States,
- its now current position = being a lender of last resort to
banking institutions that require additional credit to stay afloat.
The Federal Reserve System provides the government with a
ready source of loans and serves as the safe depository for
federal money..
The Federal Reserve Banks were created as instrumentalities to
carry out the policies of the Federal Reserve System.
The Federal Reserve is also a low-cost mechanism for
transferring funds and is an inexpensive agent for meeting
payments on the national debt and government salaries.
76
77. Notional Amounts in Circulation
This is the Risk-free rate
And is usually tied to a published rate
This rate may fluctuate out-of-sync with the instrument
77
78. 78
The Notional amount
Billions of Dollars$ 700,000,000,000
$ 700,000,000,000,000 Trillions of Dollars
Millions of Dollars$ 700,000,000
Thousands of Dollars$ 700,000
Dollars$ 700
79. Redundant positions
When you go to a Casino, the amount you take in is
significant.
You do not add up all your bets (say 100 bets of $10 each)
100 x $10 = $1,000 when in fact you only took $100 and
won 50% of the time until you lost your $100.
Therefore eliminate the redundant positions that have
no economic value
BUT redundant positions do overhang – they are not
significant until things go wrong – like in the recent
financial crisis – so watch over-exposure to a position.
When you balance your book they are redundant
79
80. Participants in the derivative market
Participants in a derivative market can be divided into:
(based on their trading motives)
1. Hedgers
2. Speculators
3. Margin Traders
4. Arbitrageurs
80
81. Example: Euronext
Euronext is a pan-European exchange based in Amsterdam,
Brussels, London, Lisbon and Paris
Its total product offering includes equities, exchange-traded
funds, warrants & certificates, bonds, derivatives, commodities
and indices
As of the first quarter of 2014, Euronext was No 1 in Europe
- with 1.300 issuers
- representing a €2.6trillion market cap
81
82. FASB – Financial Instruments
The FASB has substantially completed deliberations on its financial
instruments—classification and measurement project.
The new standard, expected to be issued later 2015, makes only
targeted changes to current GAAP, with the most significant change
related to investments in equity instruments.
Most of those investments will be required to be measured at FV,
with subsequent changes in fair value recognized in net income.
However, (a change from current U.S. GAAP) change in FV due to an
entity’s own credit risk should go to OCI.
This change does not impact other financial liabilities that are
required to be measured at FV with changes in FV recognized in
earnings, such as derivative liabilities. 82
83. FASB - ED 2013-2
The FASB’s most recent exposure draft, issued in February
2013, proposed significant changes to current U.S. GAAP
guidance.
As a result of significant negative feedback, particularly with
respect to the “solely payments of principal and interest”
criterion for classifying and measuring financial assets, the
FASB decided to abandon that approach and instead pursue
targeted amendments to current U.S. GAAP.
As a result, convergence with the IASB will not be achieved.
83