Pert 3 - Embeded Derivatives-new (1) [Compatibility Mode]

8/10/2019 Pert 3 - Embeded Derivatives-new (1) [Compatibility Mode]

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Option Contracts

obligation to buy or sell a specified item at a

. 2 type of option contracts:

, . Put option right, but not obligation to sell.

an e mer can op on exerc sa e any me o

expiration) or European option (exercisable only onma ur y a e . Can also be customized (not traded) or standard

Edited by Taufik Hidayatcontract quoted on exchange (listed options).


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Option Contracts (2)

Main features: Purchaser (holder) pays premium to seller (writer of option).

Holder has the right, but not obligation to perform; while write has. Asymmetrical pay-off profile:

Holder has limited loss due to remium and unlimited ain.

Writer has limited gain and unlimited loss.

Underlying(spot price)



- - - - - - - option

Holder of puto tion

In-the-money At-the-money Out-of-the-money

Edited by Taufik Hidayat


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Option Contracts (3)

Fair value of option contract

Fair value of an o tion = Intrinsic value + Time value

Diminishes over timeZero at expiration

Listed options = quoted priceNot traded options = Valuationmodel ( Black-Scholes model)

=

,Put option = Max [0, Notional amount x (Strike price Spot Price)



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Purchased Option Contracts: Journal Entries

At inception During life of contract Closing position or

at expirationDr Option ContractCr Gain on future

contract

Dr Cash*Cr Gain on option

contract

or Cr Option Contract

*

Dr Option contract(asset)

Cr Cash contract

Cr Option Contract

Dr Loss on option

contractCr O tion Contract

(* assume expires in-the-money. If out-of-the money, no cash entry is needed)


and record gain/loss

net settlement ofcontract

initial margin deposit


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Written Option Contracts: Journal Entries

At inception During life of contract Closing position or

at expirationDr Option ContractCr Gain on future

contract

Dr Option contractCr Gain on Option

Contract

or Dr CashCr Option contract(liability)

(Expires out-of-the-money)

contract

Cr Option Contract

Dr Loss on optionCr Cash

- -

Adjust for fair value Close out and recordRecord payment of


contract


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Call Option Contracts : illustration

On March 1, 20X5, Company A purchased 100,000 unit of callExample

option of Company B with strike price of $35 and premium $4.5.

On that date, current market price of Company B stock was. ,third party. Following prices are given:

Date Stock Price O tion Price

March 1 $38 $4.50March 31 41 6.80

April 30 43 8.25

March 1 $4.50 $3 $1.50March 31 6.80 6 0.80

Edited by Taufik Hidayat April 30 8.25 8 0.25


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Call Option Contracts: Buyer

Date Account Amount

March 1 Dr Call Option

Cr CashTo record a ment of remium

450,000

450,000$4.5 x 100,000

March 31 Dr Call OptionCr Gain on Option ContractTo record chan e in intrinsic value

300,000300,000

(6 3) x 100,000

March 31 Dr Loss on Option ContractCr Call OptionTo change in time value

70,00070,000

(0.8 1.5) x 100,000

April 30 Dr Call OptionCr Gain on Option ContractTo record change in intrinsic value

200,000200,000

(8 6) x 100,000

April 30 Dr Loss on Option ContractCr Call Option

55,00055,000


. . ,

Alternative: record the net amount


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Date Account Amount

April 30 Dr Cash

Cr Call optionTo record settlement of o tion

825,000

825,000

If company A exercise the option on April 30, 20X5 :

Date Account Amount

Dr AFS 4,300,000Dr Loss on Exercise of OptionCr Call Option

Cr Cash

25,000825,000

3,500,000o recor e exerc se an c ose op on con rac



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Call Option Contracts: Writer

Date Account Amount

March 1 Dr Cash

Cr Call OptionTo record a ment of remium

450,000

450,000$4.5 x 100,000

March 31 Dr Loss on Option ContractCr Call OptionTo record chan e in intrinsic value

300,000300,000

(6 3) x 100,000

March 31 Dr Call OptionCr Gain on Option ContractTo record change in time value

70,00070,000

(0.8 1.5) x 100,000

April 30 Dr Loss on Option ContractCr Call OptionTo change in intrinsic value

200,000200,000

(8 6) x 100,000

April 30 Dr Call OptionCr Gain on Option Contract

55,00055,000


. . ,


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Date Account Amount

, .prices are given:

Dr CashDr Call Option

3,500,000825,000

Cr Gain on Exercise of OptionTo record the exercise and close option contract

, ,

25,000



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Put Option Contracts : illustration

On March 1, 20X5, Company A purchased 100,000 unit of putExample

option of Company C with strike price of $35 and premium $2.5.

On that date, current market price of Company C stock was. ,third party. Following prices are given:

Date Stock Price O tion Price

March 1 $34 $2.50March 31 32 4.00

April 30 31 4.80

March 1 $2.50 $1 $1.50March 31 4.00 3 1.00

Edited by Taufik Hidayat April 30 4.80 4 0.80


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Date Account Amount

March 1 Dr Put Option

Cr CashTo record a ment of remium

250,000

250,000$2.5 x 100,000

March 31 Dr Put OptionCr Gain on Option ContractTo record chan e in intrinsic value

200,000200,000

(3 1) x 100,000

March 31 Dr Loss on Option ContractCr Put OptionTo record change in time value

50,00050,000

(1.0 1.5) x 100,000

April 30 Dr Put OptionCr Gain on Option ContractTo record change in intrinsic value

100,000100,000

(4 3) x 100,000

April 30 Dr Loss on Option ContractCr Put Option

20,00020,000


. . ,


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Date Account Amount

April 30 Dr Cash

Cr Put optionTo record settlement of o tion

480,000

480,000

If company A already had Company C stock (assume: no hedge

Date Account Amount

, ,

r asDr Loss on Exercise of Option

Cr Put Option

, ,80,000

480,000r To record the exercise and close option contract

, ,



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Date Account Amount

March 1 Dr Cash

Cr Put OptionTo record a ment of remium

250,000

250,000$2.5 x 100,000

March 31 Dr Loss on Option ContractCr Put OptionTo record chan e in intrinsic value

200,000200,000

(3 1) x 100,000

March 31 Dr Put OptionCr Gain on Option ContractTo record change in time value

50,00050,000

(1.0 1.5) x 100,000

April 30 Dr Loss on Option ContractCr Put OptionTo record change in intrinsic value

100,000100,000

(4 3) x 100,000

April 30 Dr Put OptionCr Gain on Option Contract

20,00020,000


. . ,


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Date Account Amount

, .prices are given:

Dr AFSDr Put Option

3,100,000480,000

Cr Gain on Exercise of OptionTo record the exercise and close option contract

, ,

80,000



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Fair Value Hedge Option ContractExample

On March 1, 20X5, Company A purchased 100,000 of CompanyD shares at $34/share.

To protect itself against a loss in value of the investment,,with strike price of $35 and premium $2.5 on the same date.Company A settle the option on Aprill 30, 20X5 (maturity date).

Following prices are given:

Date Stock Price Option Price

March 1 $34 $2.50March 31 32 3.80 April 30 31 4.00



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Fair Value Hedge Option Contract (2)

Date Stock Price Option Price

March 1 $34 $2.50March 31 32 3.80

April 30 31 4.00

Date Option Price Intrinsic Value Time Value

March 1 $2.50 $1 $1.50March 31 3.80 3 0.80

pr . .



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Date Account Amount

March 1 Dr AFS

Cr Cash

3,400,000

3,400,00034 x 100 000

March 1 Dr Put OptionCr Cash

250,000250,000

To record payment of premium $2.5 x 100,000

March 31 Dr Put OptionCr Gain on Option Contract

200,000200,000

To record change in intrinsic value (3 1) x 100,000

March 31 Dr Loss on Option Contract

Cr Put Option

70,000

70,000To record change in time value (0.8 1.5) x 100,000

March 31 Dr Loss on InvestmentCr AFS

200,000200,000

P/L


To record change in fair value of AFS (32 34) x 100,000


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Date Account Amount

April 30 Dr Loss on Investment

Cr AFSTo record chan e in fair value of AFS

100,000

100,00031 32 x 100,000

April 30 Dr Loss on Option ContractCr Put OptionTo record chan e in time value

80,00080,000

0 0.8 x 100,000

April 30 Dr Put OptionCr Gain on Option ContractTo record chan e in intrinsic value

100,000100,000

(4 3) x 100,000

April 30 Dr Cash

Cr Put Option

3,500,000

400,000r To record the exercise and close option contract

, ,



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Swap

,contractual arrangement wherein they agree to

. 2 type of basic swap:

Plain vanilla fixed-for-floating swaps in one currency. ross urrency n eres a e wap urrency swap

Fixed for fixed rate debt service in two (or more).



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Swap (2)

Interest Rate Swap: Used by companies and banks that require either fixed

or floating-rate debt. Interest rate swaps allow the companies (or banks) and

the swap bank to benefit by swapping fixed-for-floatingn eres paymen s.

Since principal is in the same currency and the same, .

Hedge using interest rate swap: as ow e ge c anges n o swap are

recognized in equity.


a r va ue e ge c anges n o swap arerecognized in P/L.


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Swap (3)

SwapBank

Pay fixedPay floating

Company A Company BReceiveReceive Floatingfixed

Issue floatingIssue fixed



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Cash Flow Hedge - Swap

Cash flow hed e : Swa from floatin to fixed rate. To protect future cash flow (interest) payments.

Changes in fair value of swap are taken to equity . .

Determining hedge effectiveness can be highly .

method, whereby no hedge ineffectiveness if: Matchin of notional amount with rinci al amount Zero fair value of swap at inception; No re a ment of interest

Edited by Taufik Hidayat Matching index interest of swap with floating rate of loan.


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Cash Flow Hedge Swap : IlustrationExample

Company A had $10 million loan with interest at LIBOR + 50basis points.

To protect itself against an increase in interest rate, Company A, .Under this contract, Company A paid interest at fixed rate of 7.75% on notional amount $10 million to Company B over 1 year

for the receipt of floating rate of LIBOR + 50 basis point. Interestsettlement were made at the end of each quarter. The rates are

Date LIBOR LIBOR + 50 bp

, . .Sept, 30 6.25% 6.75%Dec, 31 7.45% 7.95%

Edited by Taufik HidayatMarch, 31 7.50% 8.00%


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Cash Flow Hedge Swap : Ilustration (2)

Example

Fair value of swap at inception is zero.

the swap tenure. +

Pay Receive

.

Company Aprefers fixed

Company Bprefers floating

. .

LIBOR+ 50 bp

LIBOR +50 bp

+


50 bp


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Cash Flow Hedge Swap : Ilustration (4)

Date Account Amount

Example

Sept 30 Dr Interest Expense

Cr Cash

193,750

193,750

Sept 30 Dr FV adjustment (equity)Cr Interest rate swap asset/liability

72,53872,538

Dec 31 Dr Interest ExpenseCr CashTo record a ment of interest at floatin rate

168,750168,750

Dec 31 Dr Interest ExpenseCr CashTo record settlement of swa differential

25,00025,000

Dec 31 Dr Interest rate swap asset/liabilityCr FV adjustment (equity)To record fv ad ustment

82,24882,248



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Cash Flow Hedge Swap : Ilustration (5)Date Account Amount

March 31 Dr Interest Ex ense 198,750Cr CashTo record payment of interest at floating rate

198,750

March 31 Dr Cash 5,000Cr Interest ExpenseTo record settlement of swap differential

5,000

March 31 Dr FV ad ustment e uit 3,583

Cr Interest rate swap asset/liabilityTo record fv adjustment 3,583June 30 Dr Interest Ex ense 200,000

Cr CashTo record payment of interest at floating rate

200,000

June 30 Dr Cash 6,250Cr Interest ExpenseTo record settlement of swap differential

6,250


Cr Interest rate swap asset/liabilityTo record fv adjustment

,6,127


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Fair Value Hedge - Swap

Fair value hedge : Swap from fixed to floating rate: To protect from increase of value of debt.

If market rate decreases, the value of fixed rate debtincreases.

Changes in fair value of swap are taken to P/L.

Even though the debt is carried at amortised costunder PSAK 55 the carr in amount should beadjusted by its fair value P/L.

discount/premium but not amortised as long as the


.


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Cash Flow Hedge Swap : Exercise

Company A had $50 million bank loan with interest at LIBOR + 150basis points to be repaid at the end of 20X5. Interest was payablehalf-yearly on June 30 and December 31.

,entered into swap contract with Company B on January 1, 20X3.Under this contract, Company A paid interest at fixed rate of 5.5%

on notional amount $50 million to Company B over 3 year for thereceipt of floating rate of LIBOR + 150 basis point. Interest.

rates are as follows:

a e

LIBOR 4.0% 4.5% 5.0% 4.7% 4.5% 4.3%LIBOR+150 b 5.5% 6.0% 6.5% 6.2% 6.0% 5.8%



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Cash Flow Hedge Swap : Exercise (2)

The calculation of the fair value of the swap:



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Session 3

Compound Financialns rumen m e e



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Classification of Hedging

Hedge of the exposure to changes in fair value of arecognized asset or liability or an unrecognized firm

Fair value , ,or firm commitment, which is attributable to a particular risk and could affect profit or loss .

e ge

Hedge of the exposure to var a y n cas ows that(i) is attributable to a particular risk associated with a

recognized asset or liability (such as all or some futureCash flow

hedgen eres paymen on var a e e ns rumen or a g yprobable future transaction, and(ii) could affect profi t or loss .

Hedge of a netinvestment in a

Hedge of the foreign currency risk associated with aforeign operation whose financial statements are required


ore gn en yparent company.

Hedge of a Net Investment


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Applies to foreign operations whose functional currencies are the

currencies of the country where the foreign operations are located. Translation method may result in significant translation loss from

depreciating currencies.

= Cumulative change in fair value of hedging instrument (A)

Cumulative translation difference on net investment (B)

. . . Unlike a fair value hedge or a cash flow hedge, a non-derivative is

allowed to be the hedging instrument , for example, a foreign currency


oan.

Accounting for Hedge of a Net Investment


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Accounting for Hedge of a Net Investment

of a net investment is taken to other

adjustment.

limited to the translation adjustment for the net.

Any excess must be recognized currently in P/L. PSAK 55 allows the hedging instrument in this type

of hedge to be derivative or non-derivative in


applying hedge accounting.



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Hedge of a Net Investment -

Example

31/12/20X0 Parents functional currency is the dollar ($).

Acquired 100% interest in foreign company (functional currency is FC)for FC 50,000 (FC 40,000 ordinary share & FC 10,000 retainedearnings).

Loan of FC 50,000 at 5% interest taken to hedge foreign investment(due and payable on January 1, 20X2) .

Exchange rate is $1.2 to FC1.

31/12/20X1 Exchange rate is $1.40 to FC1. Average rate is $1.30 to FC1.


,

balance).



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1/1/20X1

r as .................. ,Cr Loan Payable (FC) ............. 60,000

31/12/20X1

, .

........... ,

Cr Loan Payable (FC) .............. 10,000Revalue the loan : $50,000 x 1.4 - 1.2

Dr Interest Expense .. 3,250

.............................Cr Interest Payable (FC) ......... 3,500

Accrue the interest :


3,250=50,000 x 5% x 1.3 average rate

3,500=50,000 x 5% x 1.4 closing rate



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31/12/20X1

Dr OCI Translation Adj .......... 10,000

Cr OCI - Hedge reserve ......... 10,000Close the OCI from loan and OCI from translation.

1/1/20X2

Dr Interest Payable (FC) .. 3,500Dr Loan Pa able FC ............. 70 000Cr Cash ................................... 73,500Pay the principle and interest


Compound Financial Instrument &


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There are certain financial instruments that have ahybrid or combined nature.

For example, a convertible bond is a debt instrumentwith an embedded option to convert the debtinstrument to equity shares. From the perspective of the issuer, the debt instrument is a

financial liability while the embedded option may be anequity instrument.

From the perspective of the holder of that convertible bond,the debt instrument is a financial asset and the embedded

.




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In PSAK 50, from the perspective of an issuer, thesekinds of financial instruments are termed as compoundfinancial instruments.

financial instrument to separately classify differentcomponents of the instrument in accordance with the

.

In PSAK 55, from the perspective of a holder, these kindsof financial instruments are termed as hybrid (combined)instruments. PSAK 55 requires a holder of a hybrid instrument to

the instrument if certain conditions are fulfilled.



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Compound Financial Instrument

The most im ortant com ound instruments are thosewhich incorporate some elements of liability and other

elements of equity, such as convertible bonds. It is required that whether or not fair values are available

for all components of compound instruments, full fair valuee a oca e o a y componen , w on y res ua e ng

assigned to equity component.


d l ( )


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Compound Financial Instrument (2)

Roche Grou DEU issues 2 000 convertible bonds at theExample

beginning of 2011.

The bonds have a four-year term with a stated rate of interest of 6 percent, and are issued at par with a facevalue of 1,000 per bond (the total proceeds received fromssuance o e on s are , , .

Interest is payable annually at December 31. ac on s conver e n o or nary s ares w a

par value of 1. -

is 9 percent.


C d Fi i l I (3)


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Compound Financial Instrument (3)Example

Issuance


C d Fi i l I (4)


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, ,Bonds Payable 1,805,606

JournalEntry


,

C d Fi i l I t t (5)


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Conversion of Bonds at Maturity. If the bonds are converted

at maturity, Roche makes the following entry.

,

Bonds Payable 2,000,000 ,

Share PremiumOrdinary 1,694,394

NOTE: The amount originally allocated to equity of 194,384 istransferred to the Share PremiumOrdinary account.


E b dd d D i ti


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Embedded Derivative

Derivative that is part of a hybrid financial instrument.

Hybrid Instrument

Host Instrument

Linked to underlying and changein underlying causes change in

Example is bond whose ultimate proceed are linked toprice of commodity, such as oil, or to a consumer price


index.

Embedded Derivative (2)


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recognized from the host instrument and accounted for in

-conditions are met:

Conditions for separation of embedded derivative

Economic Hybrid instrument ischaracteristics and

risk of hostnot measured at fairvalue, with changes

There is a separateinstrument with same

closely related to thatof the derivative

recognized in profitand loss

embedded derivative




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A hybrid instrument includes a non-derivative host contract and an embedded derivative with the effect that Hybrid (Combined)

Contract

instrument vary in a way similar to a stand-alone derivative. Host Contract

However, a derivative that is attached to afinancial instrument but is contractuallytransferable inde endentl of that instrument or

EmbeddedDerivative

has a different counterparty from that instrument,is not an embedded derivative, but a separate

.



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Embedded Derivative : Separation Criteria


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Embedded Derivative : Separation Criteria

Edited by Taufik HidayatPSAK 55

Embedded Derivative : Not Closely Related


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Embedded Derivative : Not Closely Related

A put option embedded in an instrument that enables theholder to require the issuer to reacquire the instrument for an amount of cash or other assets that varies on the basis of

e c ange n an equ y or commo y pr ce or n ex. An option or automatic provision to extend the remaining

.

Equity-indexed interest or principal payments embedded in a.

Commodity-indexed interest or principal payments

embedded in a host debt instrument.


Embedded Derivative : Closely Related


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Embedded Derivative : Closely Related

An embedded derivative in which the underl in is aninterest rate or interest rate index that can change the

amount of interest that would otherwise be paid or received on an interest-bearing host debt contract. An embedded foreign currency derivative that provides a

s ream o pr nc pa or n eres paymen s a aredenominated in a foreign currency and is embedded in a

.


The Separated Embedded Derivative


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The Separated Embedded Derivative

If an embedded derivative is se arated the host contract isaccounted for

under PSAK 55 if it is a financial instrument , and in accordance with other appropriate accounting

standards if it is not a financial instrument .

PSAK 55 does not address whether an embeddedderivative is presented separately in the financials a emen s.

The separated embedded derivative is similar to a simple

derivatives.


Embedded Derivatives as Combined


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derivatives, an entity may designate the entire hybrid

combined contract as a financial asset or financialliability at fair value through profit or loss unless:1. the embedded derivative does not significantly modify

the cash flows that otherwise would be required by thecontract; or

2.it is clear with little or no analysis when a similar hybridinstrument is first considered that separation of the

,prepayment option embedded in a loan that permits theholder to re a the loan for a roximatel its amortised


cost.

Embedded Derivatives : Unable to


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If an entit is re uired b PSAK 55 to se arate anembedded derivative from its host contract, but is unable to

measure the embedded derivative separately (either atacquisition or subsequently), the entity is required to designate the entire hybrid

con rac as a a r va ue roug pro or oss.


Embedded Derivatives : Example


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Ton Finance Ltd invested in bond that would convertible toshares of issuing company (Roche Group) before maturity.

Fair value of bond was $3 million and fair value of embedded derivative was $500.000. Analysis:

The investment comprises two elements: bond (host) andconversion option (embedded derivative).

If investment is desi nated as FVTPL se aratin the embeddedderivative from the host is not permitted.

The investment cannot be classified as HTM because of conversion.

If investment is designated as AFS, separating the embeddedderivative from the host is required since 3 conditions in PSAK 55


are met.



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If the investment is desi nated as AFS se aratin the embeddedderivative from the host is required since 3 conditions in PSAK 55are met.

Available for Sale 2,500,000Embedded Derivative 500,000JournalEntr

Cash3,000,0

Chan es in FV of conversion o tion are reco nized in P/L unlessthe option is part of cash flow hedge.


Sources:


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. Lam & Lau Intermediate Financial Reporting, 2 nd

. Baker, Christensen, Cottrell Advanced Financial

ccoun ng, . Mackenzie, et al Interpretation & Application of

IFRS 2011. Kieso, et al Intermediate Accounting: IFRS Adapted.


au _

Documents

Pert 3 - Embeded Derivatives-new (1) [Compatibility Mode]