CHAPTER 13

BASIC DERIVATIVES

Bermudez, Jelyn
Gabertan, Erlinda B.
 Module 13

Basic Derivatives

Related standards:

PFRS 9 Financial Instruments

PAS Financial Instruments: Presentation

PFRS Financial Instruments: Disclosures

Learning Objectives

1. State the characteristics of a derivative. Give examples of derivatives.

2. State the purposes of a acquiring derivatives.

3. Account or the derivatives that are not designed as hedging instruments.

Introduction

A few decades ago, derivatives were considered off-balance sheet items, meaning they were
not separately accounted or in the financial statements. However, because o the risks inherent
in engaging in derivative transactions and their potential for abusive use reporting standards
now require proper accounting and disclosure of derivatives. Many companies have incurred
substantial losses on derivatives, including ENRON, Procter & Gamble, Barings PLC, DELL
Computer, and so on. Users of financial statements, therefore, need sufficient information on
an entity’s derivative transactions in order for them to properly assess the associated.
Purpose of derivatives

The purpose of obtaining derivatives is either:

a. to speculate (incur risk)

b. to hedge (avoid or manage risk)

The use of derivatives for speculations purposes is generally discouraged because of the high
risk associated with it. More commonly, derivatives are used to manage risks, particularly
financial risks.

Risk

Risk is the possibility that an event will occur having an adverse effect on the achievement of an
entity’s objectives. Risk is measured interim of impact (possible loss) and likelihood
(probability).

Financial Risk

The risk of a possible future change in interest rate, financial instrument price, index price,
credit rating, or other variable.

Financial risks including the following:

1. Credit Risk

Is the risk that one party to a financial instrument will cause a financial loss for the
other party by failing to discharge an obligation.

2. Liquidity Risk

Is the risk that an entity will encounter difficulty in meeting obligations associated with
financial liabilities that are settled by delivery cash or another financial asset.
3. Market Risk

Is the risk that the fair value or future cash flows of a financial instrument will fluctuate
because of changes in market prices.

Three types of Market risk:

a. Currency risk - is the risk that the fair value or future cash flows of a financial instrument
will fluctuate because of changes in foreign exchange rates.

b. Interest rate risk - is the risk that the fair value or future cash flows of a financial
instrument will fluctuate because of changes in market interest rates.

c. Other price risk - the risk that the fair value or future cash flows of a financial
instrument will fluctuate because of changes in market prices (other than those arising
from interest rate risk or currency risk), whether those changes are caused by
factors specific to the individual financial instrument or its issuer, or factor
affecting all similar financial instruments traded in the market.

Definition of a Derivative

A derivative is a financial instrument or other contract that derives its value of some other
underlying asset or other instrument.

Characteristics of s derivative

a. It’s value changes in response to the change in an underlying

b. It requires no initial net investment (or only a very minimal initial ner investment)

c. It is settled at a future date

Underlying

Is a specified price, rate, or other variable (e.g., interest rate, security or commodity price,
foreign exchange rate, index of prices or rates, etc.), including a scheduled event (e.g., a
payment under contract) that may or may not occur.

Notional amount

Is a specified unit of measure (e.g., number of currency units, number of shares, kilos, pounds,
etc.). For example, the value of derivative after initial recognition is determined by multiplying
the agreed number of shares (notional amount) by the change in the market price of the shares
(underlying).

Common types of derivatives

1. Forward contract

Is an agreement between two parties to exchange a specified amoun of a commodity,

security, or foreign currency at a specified date in the future at a pre-agreed price.

y stated, a forward is a contract to buy or sell commodity, security, or foreign currency:

a. at a specified amount or quantity

b. at a specified future date

c. at a price which is agreed upon right now

2. Futures contract

A contract traded on an exchange that allows an entity to buy or sell a specified

quantity of commodity or a financial security at a specified future date.
 FORWARDS VS FUTURES
 Forwards are private contracts  Futures are traded in a market.
which are most likely over-the-
counter (OTC) transactions
 Forwards are customized  Futures are standardized
contracts. contracts.
 Forwards are private contracts  A party in a futures contract may
between two private parties who never know the other contracting
interact directly with each other. party because they interact
indirectly through a broker.
 Forwards may be settled by actual  Futures are normally settled
delivery of the agreed-upon through net cash payment.
commodity or net cash payment.

3. Option

A contract that gives the holder the right, but not the obligation, to buy or sell an asset
at a specified price any time during a specified period in the future. When th eholder
exercises his right, the writer if the option is obligated to perform his obligation on the
option contract.

Types of options to exercise date

a. European options - can be exercised only at expiration time.

b. American options - can be exercised any time prior to maturity.

c. Bermudan options - can be exercised before maturity bu ton certain pre-determined days.
Types of options as to right of holder:

a) Call option - an option to buy.

b) Put option - and option to sell.

 When you call pizza delivery, you are buying.

Type of option Strike price = Strike price < Strike price >

Market price Market price Market price

Call (buy) At the money In the money Out of the
money
Put (sell) At the money Out of the money In the money

 At the money - the holder may or may not exercise th eoption; no gain or loss in
exercising.

 In the money - the holder should exercise; gain in exercising.

 Out of the money - the holder should not exercise; loss in exercising.

Example 1:

You purchased a call option from Mr. Monkey. The option gives you the right to buy banana for
₱5.00 (strike price or exercise price).

Case 1: At exercise date, banana costs ₱12 at Seven Eleven.

 The option is in the money. You will save ₱7 by buying from Mr. Monkey.

Case 2: At exercised date, bananas costs ₱3 at Seven Eleven.

 The option is out of the money. You are better off buying from Mr. Monkey.

Example 2:

You purchased a put option from Ms. Banana. The option gives you the right to sell a monkey
for ₱1,000.

Case 1: At exercise date, monkey is being sold for ₱800 in the market.

 The option is in the money. You will gain ₱200 from selling monkey to Ms. Banana.

Case 2: At exercise date, monkey is being sold for ₱1,500 in the market.

 The option is out of the money. You are better off selling monkey in the market.

4. Swap

A contract in which two parties agree to exchange payments in the future based on the
movement of some agreed-upon price or rate.

Common examples include:

 Interest rate swap - A contract between two parties who agree to exchange future interest
payments on a given loan amount. Usually, one set of interest payments is based on a fixed
interest rate and other is based on a variable interest rate.

 Foreign currency swap - A contract between two parties who agree to exchange a sum of
money in one currency for another currency.

5. Caps, Floors and Collars

Are essentially options designed to shift the risk of an upward and/or downward
movement in variables, such as interest rates. These are normally linked to a notional
amount and a reference rate.
 If the interest rate does not go up but rather declines, the option holder would have
paid the premium, and there is no settlement.

Interest rate collar is a fixation of both a cap and floor, so that payment will be
triggered if the rate goes above the collar or falls below the floor.

6. Swaption

Is an option on a swap. The option provides the holder with the right to enter into a
swap at a specified future date at specified terms. This derivative has characteristics of an
option and a swap.

7. Weather derivative

A contract that requires payment based on climatic, geological or other physical

variables.

Measurement of derivatives

All derivatives are measured at fair value. The accounting for fair value changes depends on
whether the derivative is:

a. Not designated as a hedging instrument

b. Designated as fair value hedge

c. Designated as cash flow hedge

No hedging designation
 Derivatives that are not designated as hedging instruments are considered obtained for
speculation on the direction of the movement of prices, rates or other underlying. Non-
designated derivatives are accounted for as held for trading securities.

Accounting for non-designated derivatives

Illustration 1: Forward contract - No hedging designation

ABC Co. expects that value of the yen to decrease in the next 30 days. Accordingly, on
December 15, 20x1, ABC Co. enters into a 30-day forward contact to sell 1,000,000 yens at the
forward rate of ₱0.47. On December 31, 20x1, the forward rate was ₱0.485 and by January 15,
20x2, the spot rate moved to ₱0.46.

 December 15, 20x1 (Contract date)

Hedged item - None Forward contract (Derivative)

Dec. 15, 20x1

No entry

 December 31, 20x1 (Reporting date)

The value of the derivative is computed as follows:

Sales price under the forward contract (1M x .47) 470,000

Sales piece in the market (1M x .485) 485,000

Loss/ Derivative liability 15,000

The entry on December 31, 20x1 is as follows:

Hedged item - None Forward contract (Derivative)

Dec. 31, 20x1

Loss on forward contract 15,000

 Forward contract (liability) 15,000

[(0.485 - 0.47) x 1M]

 January 15, 20x2 (Settlement date)

Variation #1: Gross Settlement

Hedged item - None Forward contract (Derivative)

Jan. 15, 20x2

Cash - local currency……………….470,000

(1M x 0.47 agreed rate)

Forward contract (liability)…….15,000

Cash - foreign currency…………..460,000

(1M x 0.46 current rate)

Gain on forward contract…………25,000

The net gain recognized over the term of the forward contract is ₱10,000. This is computed as
follows:

Selling price using forward contract (1M x 0.47) 470,000

Selling price in the market - 1/15/x2 (1M x 0.46) (460,000)

Net gain on the forward contract 10,000

OR

Loss - 12/31/x1 (15,000)

Gain - 1/15/x2 25,000

Net gain on the forward contract 10,000

Illustration 2 : Futures contract - No hedging designation

On December 1, 20x1, ABC Co. enters in a silver futures contract to purchase 1,000 ounces of
silver on February 1, 20x2 for ₱200 per ounce. The broker requires an initial deposit of ₱20,000.
The quoted prices per ounce of silver are as follows:

December 1, 20x1 December 31, 20x1 February 1, 20x2

200 190 185

 December 1, 20x1 (Contract date)

Hedged item - None Futures contract (Derivative)

Dec. 1, 20x1

Deposit with broker…………20,000

Cash………………………………….20,000

 December 31, 20x1 (Reporting date)

Hedged item - None Futures contract (derivative)

Dec. 31, 20x1

Loss on futures contract…………….10,000

Futures contract (liability)…………10,000

[(200 - 190) x 1,000]

NOTES:

 Futures contracts normally require an initial margin deposit with the broker. The initial
margin deposit represents a small fraction of the value of the futures contract. This is
recorded as ‘’Deposit with future broker’’, which is a regular receivable account and not a
derivative.

 On the other hand, the broker sets up an account for the entity (investor). This account
reflects the subsequent increases or decreases in the fair value of the futures contract.
When fair value increases, the entity maybe able to withdraw cash from the account. When
fair value decrease, the entity maybe required to pay additional cash to maintain the
specified minimum balance in the account.

 Futures contracts are normally settled on a net cash basis. On settlement date, the initial
margin deposit is returned to the entity along with any gain earned on the futures contract.
In case of loss, the loss is offset against the initial margin deposit and any remaining
amount is returned to the entity.

ABC Co. recognizes a liability and a loss because the current price is ₱190 but the ‘’fixed’’
purchase price is ₱200, which is higher. This condition is unfavourable t ABC Co.

 February 1, 20x2 (Settlement date)

Hedged item - None Futures contract (Derivative)

Feb. 1, 20x2

Loss on futures contract……….5,000

[(190 - 185) x 1,000]

Futures contract (liability)…….10,000

Cash - local currency……………..5,000

Deposit with broker………………20,000

Alternative Journal Entries: Simple entries

The simple entries on February 1, 20x2 are as follows:

Hedged item - None Futures contract (Derivative)

Feb. 1, 20x2

Loss on futures contract……………5,000

[(190 － 185) x 1,000)

Futures contract (liability)………..5,000

Feb. 1, 20x2

Futures contract (liability)………….15,000

(10K liability + 5K liability)

Cash - local currency…………………5,000

Deposit with broker………………..20,000

NOTES:

 The party in a futures contract who agrees to sell a commodity is said to be in the short
position. The party who agrees to purchase a commodity is in the long position.

 If prices fall, the entity in the short position recognizes gain because he can still sell at a
higher price. On the other hand, the entity on the long position recognizes loss because he
will be required to purchase at a higher price.
Illustration 3 : Put option - No hedging designation

On December 15, 20x1, ABC Co. purchased a foreign currency put option for ₱7,500 to sell
1,000,000 yens at ₱0.47 on January 15, 20x2.

Dec. 15, 20x1 Dec. 31,20x1 Jan. 15, 20x2

Spot rate ₱0.48 ₱0.49 ₱0.46
Fair value of put option 7,500 5,000 8,000

 The put option gives ABC Co. the right to sell 1M yens for 470,000 (1M x 0.47). ABC Co. paid
₱7,500 for this right.

If the spot rate on January 15, 20x2 is:

Less than the ₱ 0.47 strike Greater than the ₱0.47 strike Equal to the ₱0.47 strike
price (in the money) price (out of the money) price (at the money)
ABC exercises the option ABC discards the option and ABC Co. Will be indifferent
and receives the ₱470,000 sells the 1M yens in the whether to exercise the
pre-agreed sale price. market at the higher rate. The option or not.
carrying amount of the option
is treated loss.

The entry on December 15, 20x1 is as follows:

 Hedged item - None Put option (Derivative)
Dec. 15, 20x1

Put option………………….7,500

Cash……………………………..…7,500

The entry on December 31, 20x1 is as follows:

Hedged item - None Put option (Derivative)

Dec. 31, 20x1

Loss on put option………..2,500

Put option………………………2,500

(7,500 - 5,000)

Gross Settlement

The entries on January 15, 20x2 are as follows:

Hedged item - None Put option

Jan. 15, 20x2

Cash - local currency………………..470,000

(1M x 0.47 option price)

Put option (7,500 - 2,500)…………..5,000

Cash - foreign currency………………460,000

(1M x 0.46 spot rate)

Gain on put option……………………..5,000

Net Settlement

The entries on January 15, 20x2 are as follows:

Hedged item - None Put option (Derivative)

Jan. 15, 20x2

Cash - local currency………………..10,000

[(1M x (0.47 - 0.46)]

Put option (7,500 - 2,500)…………..5,000

Gain on put option……………………..5,000

Variation: Out of the money

Assume that the spot rate on January 15, 20x2 is ₱0.48. The entry is as follows:

Hedged item - None Put option (Derivative)

Jan. 15, 20x2

Loss on put option………………………10,000

Put option (7,500 - 2,500)……………5,000

Gain on put option………………………5,000

Loss - 12/31/x1 2,500

Loss - 1/15/x2 5,000

Total loss (equal to ‘option premium’) 7,500

Illustration 4: No hedging designation - Call option

On April 1, 20x1, ABC Co. enters into a call option contract with an investment banker which
gives ABC Co. the option to purchase 1,000 XYZ., Inc. shares of stocks at a strike price of ₱100
per share. The call option expires on July 1, 20x1. ABC Co. pays the investment banker ₱600 for
the call option. The market price of the XYZ, Inc. shares on April 1, 20x1 is ₱100 per share.

Additional information:

April 1, 20x1 June 30, 2ox1

Market price of XYZ, Inc. shares ₱100/sh. ₱106/sh.
Time value of option ₱600 ₱400

NOTES:

 The call option gives ABC Co. the right to purchase 1,000 shares for ₱100 per share. ABC Co
paid ₱600 for this right.

 The 1,000 shares are referred to as the notional amount.

 The ₱600 payment to the investment banker is referred to as the option premium, which is
much less than the cost of purchasing the shares directly.

 The option premium indicates the value of the call option at this point in the time. The
option premium consists of the sum of intrinsic value and time value.

Option premium = Intrinsic value + Time value

 At this point in time, the intrinsic value is zero because the market price of the shares is
equal to the exercise price ( ₱100 market price less ₱100 exercise price equals ₱0).

 On contract date, the option has a fair value greater has zero. This is due to the expectation
that the market price of the XYZ, Inc. shares will increase above the option price during the
option term (often referred to as the time value of the option). The time value of the
option is estimated using option-pricing models.
 The equation above will be shown as follows:

Option premium = Intrinsic value + Time value

600 = 0 + 600

The entry on April 1, 20x1 is as follows:

Hedged item - None Call option (Derivative)

April 1, 20x1

Call option…………………….…600

Cash……………………………..…..600

The entries on June 30, 20x1 are as follows:

Hedged item - None Call option (Derivative)

June 30, 20x1

Call option………………………….600

[(106 - 100- x 1,000]

Gain on call option……………600

June 30, 20x1

Loss on call option……………..200

(600 - 400)

Call option……………………….200
NOTE:

 If the case the option is out of the money, the entity need not recognize a loss from the
change in intrinsic value because the option is not designated as a hedging instrument.
Only the change in the time value will be accounted for. The maximum loss that would be
recognized in an option is the premium paid which is equal to the time value of the option
on initial recognition. If the option is out of the money, the holder simply discards the
option and treat the acquisition cost as loss.

The entry on July 1, 20x1 is as follows:

Hedged items - None Call option (Derivative)

July 1, 20x1

Cash…………………………………….6,000

[(106 - 100) x 1,000]

Loss on call option……………….400

Call option…………………….…..6,400

(600 + 6,000 - 200)

The net cash receipt can also be analyzed as follows:

Purchase shares at ₱100 strike price (₱100 x 1,000 shares) 100,000

Sell the shares at ₱106 current market price (₱106 x 1,000 shares) 106,000

Net cash settlement (receipt) 6,000

Illustration 5: Interest rate swap (payment a maturity) - No hedging

The current rate on January 1, 20x1 is 8%. ABC Co. believes that market rates will increase in
the future. Accordingly, on January 1, 20x1, ABC Co. enters rate swap for a notional amount of
₱1,000,000. Under the agreement, ABC Co. shall receive variable interest and pay fixed interest
based on a fixed rate of 8%. The interest rate swap will be settled net on December 31, 20x2.

The following are the current market rates:

January 1, 20x1 8%

January 1, 20x2 10%

 January 1, 20x1

Hedged item - None Interest rate swap (Derivative)

Jan. 1, 20x1

No entry
 December 31, 20x1

The net cash settlement on the swap is determined as follows:

20x1 20x2
Receive variable 80,000 100,000
Pay 8% fixed 80,000 80,000
Net cash settlement - receipt - 20,000

 The interest rates used are the current rates at the beginning of the year. (1M x 8% =
80,000) & (1M x 10% = 100,000).

The net cash settlement in 20x2 is discounted to determine the fair value of the derivative on
December 31, 20x1:

Net cash Settlement - receipt (due on Dec. 31, 20x2) 20,000

PV of 1 @10%, n=1 0.90909

Fair value of derivative - 12/31/x1 (asset) 18,182

 The entry on December 31, 20x1 is as follows:

Hedged item - None Interest rate swap (Derivative)

Dec. 31, 20x1

Interest rate swap……………………18,182

Gain on interest rate swap………..18,182

 December 31, 20x2

Hedged item - None Interest rate swap (Derivative)

Dec. 31, 20x2

Cash…………………………….……..20,000

Interest rate swap……………………18,182

Gain on interest rate swap……….1,818

Illustration 6: Interest rate swap (Periodic payments) - No hedging

The current rate on January 1, 20x1 is 9%. ABC Co. believes that market rates will increase in
the future. Accordingly, on January 1, 20x1, ABC Co. Enters into a interest rate swap for a
notional amount of ₱1,000,000. Under the agreement, ABC Co. shall receive variable interest
and pay fixed interest based on a fixed rate of 9%. Swap payments shall be made at the end of
each year in the next three years.

The following are the current market rates:

January 1, 20x1 9%
 January 1, 20x2 8%

January 1, 20x3 12%

 January 1, 20x1

Hedged item - None Interest rate swap (Derivative)

Jan. 1, 20x1

No entry

 December 31, 20x1

The net cash settlement on the swap is determined as follows:

20x1 20x2
Receive variable (1M x 9%) & (1M x 8%) 90,000 80,000
Pay 9% fixed 90,000 90,000
Net cash settlement - payment - (10,000)

The net cash settlement is discounted to determined the fair value of the derivative on
December 31, 20x1.

Net cash payment (due annually starting on Dec. 31, 20x2) (10,000)

PV of ordinary annuity of 1 @8%, n=2 1.783265

Fair value of derivative - 12/31/x1 (liability) (17,833)

The entry on December 31, 20x1 is as follows:

Hedged item - None Interest rate swap (Derivative)

 Dec. 31, 20x1

Loss on interest rate swap…………17,833

Interest rate swap……………………17,833

 December 31, 20x2

The entry to record the first cash settlement on December 31, 20x2 is as follows:

Hedged item - None Interest rate swap (Derivative)

Dec. 31, 20x2

Interest rate swap…………………..10,000

Cash………………………………………10,000

The net cash settlement in 20x3 is determined as a basis for adjusting the fair value of the
interest rate swap on December 31, 20x2.

20x3
Receive variable (1M x 12%) 120,000
Pay 9% fixed 90,000`
Net cash settlement - receipt 30,000

The net cash settlement is discounted to determine the fair value of the derivative on
December 31, 20x2.

Net cash receipt (due on Dec. 31, 20x3 - maturity date) 30,000
Multiply by: PV of 1 @12%, n=1 0.892857

Fair value of derivative - 12/31/x2 (asset) 26,786

The change in the fair value of the interest rate swap is determined as follows:

Fair value of interest rate swap - Dec. 31, 20x2 - (asset) 26,786

Less: Carrying amount of the interest rate swap - Dec. 31, 20x2 (7,833)

(17,833 liability－10,000 net cash settlement) - (liability)

Change in fair value - gain 34,619

The entry to adjust the carrying amount of the derivative is as follows:

Hedged item - None Interest rate swap (Derivative)

Dec. 31, 20x2

Interest rate swap……………………….34,619

Gain on interest rate swap………….34,619

Interest rate swap

17,833 12/31/x1

12/31/x2 10,000

12/31/x2 34,619
26,786 bal. (Debit/asset)
 Equal to fair value

 December 31, 20x3

The entry on December 31, 20x3 is as follows:

Hedged item - None Interest rate swap (Derivative)

Dec. 31, 20x3

Cash………………………………………..30,000

Interest rate swap……………………..26,786

Gain on interest rate swap………..3,214

Illustration 7: ‘’Receive fixed, pay variable’’ interest rate swap

The current rate on January 1, 20x1 is 10%. ABC Co. believes that market rates will decrease in
the future. Accordingly, on January 1, 20x1, ABC Co. enters into an interest rate swap for
notional amount of ₱1,000,000. Under the agreement, ABC Co .shall receive fixed interest at
10% and pay variable interest. Swap payments shall be made at the end of each year in the next
three years.

The following are the current market rates:

January 1, 20x1 10%

January 1, 20x2 12%

January 1, 20x3 14%

 January 1, 20x1

Hedged item - None Interest rate swap (Derivative)

January 1, 20x1

No entry

 December 31, 20x1

The net cash settlement on the swap is determined as follows:

20x1 20x2
Receive 10% fixed 100,000 100,00
Pay variable (1M x 10%) & (1M x 12%) 100,000 120,000
Net cash settlement - payment - (20,000)

The net cash settlement is discounted to determine the fair value of the derivative on
December 31, 20x1.

Net cash payment (due annually starting on Dec. 31, 20x2) (20,000)

PV of ordinary annuity of 1 @12%, n=2 1.69005

Fair value of derivative - 12/31/x1 (liability) (33,801)

The entry ia as follows:

Hedged item - None Interest rate swap (Derivative)

Dec. 31, 20x1

Loss on interest rate swap……….33,801

Interest rate swap…………………..33,801

 December 31, 20x2

The entry to record the first cash settlement on December 31, 20x2 is as follows:

Hedged item - None Interest rate swap

Dec. 31, 20x2

Interest rate swap……………….20,000

Cash…………………………………..20,000

The net cash settlement in 20x3 is determined as a basis for adjusting the fair value of the
interest rate swap on Dec. 31, 20x2.

20x3
Receive 10% fixed 100,000
Pay variable (1M x 14%) 140,000
Net cash settlement - payment (40,000)

The net cash settlement discounted to determine the fair value of the derivative on December
31, 20x2.

Net cash payment (due on Dec. 31, 20x3 - maturity date) (40,000)

Multiply by: PV of 1 @14%, n=1 0.8771929832

Fair value of derivative - 12/31/x2 (liability) (35,088)

The change in the fair value of the interest rate swap is determined as follows:

Fair value of interest rate swap - Dec. 31, 20x2 - (liability) 35,088

Carrying amount of interest rate swap - Dec. 31, 20x2 (13,801)

(33,801 liability - 20,000 net cash settlement) - (liability)

Change in fair value - loss (increase in liability) 21,287

The entry to adjust carrying amount of the derivative:

Hedged item - None Interest rate swap (Derivative)

Dec. 31, 20x2

Loss on interest rate swap……..21,287

Interest rate swap…………………….21,287

 December 31, 20x3

Hedged item - None Interest rate swap (Derivative)

Dec. 31, 20x3

Interest rate swap………………………………35,088

Loss on interest rate swap (squeeze)….4,912

Cash…………………………………………………..40,000

Additional illustrations:
Illustration 1: Forward contract

On March 1, 20x1, ABC Co. Sold inventory to a foreign company for FC 1,000,000 (FC means
foreign currency) when the spot exchange rate is FC 40: ₱1. The payment is due on April 1,
20x1.

ABC Co. is concerned about the possible fluctuation in exchange rate, so on this date, ABC Co.
entered into a forward contract to sell FC 1,000,000 for ₱25,000 to a broker. According to the
terms of the forward contract, if FC 1,000,000 is worth less than ₱25,000 on April 1, 20x1, ABC
Co. shall receive from the broker the difference; it is worth more than ₱25,000, ABC Co. shall
pay the broker the difference.

Case #1:

If the exchange rate on April 1, 20x1 is FC35: ₱1, how much is the net cash settlement?. Indicate
whether it is a receipt or payment.

Solution:

Fixed selling price ₱25,000

Selling price at current spot rate (1M ÷ 35) 28,571

Excess - payment to broker (₱3,571)

Case #2:

If the exchange rate on April 1, 20x1 is FC50: ₱1, how much is the net cash settlement?. Indicate
whether it is receipt or payment.

Solution:

Fixed selling price ₱25,000

Selling price at current spot rate (1M ÷ 50) 20,000

Deficiency - receipt from broker ₱5,000

Case #3:

If the exchange rate on March 31, 20x1 is FC45: ₱1, how much is the fair value of the interest
rate swap?. Indicate whether it is a derivative asset or liability.

Solution:

Fixed selling price ₱25,000

Selling price at current spot rate (1M ÷ 45) 20,000

Fair value of forward contract - receivable (asset) ₱2,778

Illustration 2: Forward Contract

ABC Co. does printing jobs for various customers. On January 1, 20x1, ABC Co. forecasted the
purchase of 1,000 reams of paper in the next quarter. The expected purchase date is on April
15, 20x1.

ABC Co .expects that the price of paper will fluctuate because of the upcoming elections. Thus,
on January 1, 20x1, ABC Co. enters into a forward contract to purchase 1,000 reams of paper at
a forward rate of ₱600 per ream. If the market price on April 15, 20x1 is more than ₱600, ABC
Co. shall receive the difference from the broker. On the other hand, if the market price less
than ₱600, ABC Co shall pay the difference to the broker. The forward contract will be settled
pay the difference to the broker. The forward contract will be settled net on April 15, 20x1. The
discount rate is 10%.

Requirement (a): If the price of paper is ₱700 per ream on March 31, 20x1, how much is the

Derivative asset (liability) to be recognized in ABC Co.’s first quarter financial statements?.

Solution:
Fixed purchase price (₱600 x 1,000) 600,000

Purchase price at current market price (₱700 x 1,000) 700,000

Derivative asset - receivable from broker 100,000

Requirement (b): If the price of paper is ₱550 per ream on March 31, 20x1, how much is the
derivative asset (liability) to be recognized in ABC Co.’s first quarter financial statements?.

Solution:

Fixed purchase price (₱600 x 1,000) 600,000

Purchase price at current market price (₱550 x 1,000) 550,000

Derivative liability - payable to broker (50,000)

Illustration 3: Forward contract - Present value

ABC Co. Produces feeds for hogs and chicken. In its long-term budget completed on
November1, 20x1, ABC Co. Forecasts a purchase of 100,000 kilos of corn on January 1, 20x3.

To protect itself from fluctuation in prices, ABC Co. Enters into a forward contract on November
1, 20x1 to purchase 100,000 kilos of corn for ₱5,000,000 (or ₱50 per kilo). The forward contract
will be settled net on January 1, 20x3.

Requirement (a): What is the notional value of the forward contract?.

Answer:

₱5,000,000 (100,000 kilos notional figure x ₱50 forward price)

Requirement (b): If the current market price of corn is ₱65 per kilo on December 31, 20x1,
what amount of derivative asset (liability) shall be reported in ABC Co.’s 20x1 year-end financial
statements?. The appropriate discount rate is 10%.

Solution:

Fixed purchase price (100,000 x ₱50) 5,000,000

Purchase price at current market price (100,00 x ₱65) 6,500,000

Receivable from broker 1,500,000

Multiply by: PV of 1 @10%, n=1 0.90909

Fair value of forward contract (asset) 1,363,635

Requirement (c): If the current market price of corn is ₱40 per kilo on December 31, 20x2, what
amount of derivative asset (liability) shall be reported in ABC Co.’s 20x2 year-end financial
statements?. The appropriate discount rate is 10%.

Solution:

Fixed purchase price (100,000 x ₱50) 5,000,000

Purchase price at current market price (100,00 x ₱40) 4,000,000

Receivable from broker (1,000,000)

Multiply by: PV of 1 @10%, n=0 1

Fair value of forward contract (1,000,000)

Illustration 4: Futures contract

ABC Co. has the following futures contract:

Quantity Futures price - Market price

1/1/x1 - 12/31/x1
1. ‘’Long’’ futures contract to 100 2,000 1,800
purchase gold.
2. ‘’Long’’ futures contract to 200 1,600 1,900
purchase silver
3. ‘’Short’’ futures contract to sell 1,000 250 220
coffee beans
4. ‘’Short’’ futures contract to sell 1,500 60 75
potatoes

Requirement: Compute for the total net derivative asset (liability) on December 31, 20x1.

Solution:

‘’Long’’ futures contract to purchase gold:

Fixed purchase price (₱2,000 x 100) 200,000

Purchase price at current market price (₱1,800 x 100) 180,000

Payable to broker (20,000)

‘’Long’’ futures contract to purchase silver:

Fixed purchase price (₱1,600 x 200) 320,000

Purchase price at current market price (₱1,900 x 200) 380,000

Receivable from broker 60,000

‘’Short’’ futures contract to sell coffee beans:

Fixed purchase price (₱2500 x 1,000) 250,000

Purchase price at current market price (₱220 x 1,000) 220,000

Receivable from broker 30,000

‘’Short’’ futures contract to sell potatoes:

Fixed purchase price (₱60 x 1,500) 90,000

Purchase price at current market price (₱75 x 1,500) 112,500

Payable to broker (22,500)

Net derivative asset 47,500

Illustration 5: Call option

On May 6, 20x1, ABC Co. entered into a firm commitment to purchase equipment from a
foreign company for FC 1,000,000 when the exchange rate was FC 40: ₱1. Payment is due on
June 1, 20x1.

ABC Co. is concerned about the possible fluctuation in exchange rates, so on this date, ABC Co .
entered into a call option to purchase FC 1,000,000 for ₱25,000 to a broker. ABC Co. paid
₱1,000 for the purchased option.

Case #1:

If the exchange rate on June 1, 20x1 is FC 35: ₱1, how much did ABC Co. save by purchasing the
call option?.
Solution:

Purchase price using the option 25,000

Purchase price without the option (1M ÷ 35) 28,571

Savings from exercising the option - gross 3,571

Less: Cost of purchased option (1,000)

Net saving from call option 2,571

Case #2:

If the exchange rate on June 1, 20x1 is FC 50: ₱1, how much did ABC Co. Save by purchasing the
call option?.

Solution:

Purchase price using the option 25,000

Purchase price without the option (1M - 50) 20,000

Saving from exercising the option - gross -

Illustration 6: Put option

On March 31, 20x1, ABC Co. acquired for ₱10,000 a put option which entitles ABC Co. to sell
20,000 units of a commodity for ₱220 per unit. The option expires on July 1, 20x1. on July 1,
20x1, the current market price of the commodity is ₱250 per unit.

Requirement: How much is the loss on the put option to be recognized by ABC Co. in its 20x1
financial statements?
Solution:

Sale price using the option (₱220 x 20,000) 4,400,000

Sale price without the option (₱250 x 20,000) 5,000,000

Savings from exercising the option - gross -

ABC Co would have been better off not to have purchased the put option. Since an option gives
the holder the right, and not the obligation, to buy or sell, ABC Co. simply writes off the cost of
the option as loss. Accordingly, ABC Co. recognizes ₱10,000 loss on the option in its 20x1
financial statements.

Answer: ₱10,000 loss on put option

Illustration 7: Call option

On October 1, 20x1, ABC Co. acquired for ₱10,000 a call option which entitles ABC Co. to
purchase 20,000 units of a commodity for ₱220 per unit. The option is exercisable on March 31,
20x2. The call option was not designated as a hedging instrument.

The following are the current market prices:

October 1, 20x1 220

December 31, 20x1 240

March 31, 20x1 250

Requirements: Compute the following:

a. Derivative asset (liability) on December 31, 20x1.

b. Unrealized gain (loss) on December 31, 20x1.

c. Net cash settlement - receipt (payment) - on March 31, 20x2.

d. Realized gain (loss) on the call option on March 31, 20x2.

Solutions:

Requirement (a): Derivative asset (liability) - December 31, 20x1

Fixed purchase price (₱220 x 20,000) 4,400,000

Purchase price at current market price (₱240 x 20,000) 4,800,000

Derivative asset - receivable from broker 400,000

Requirement (b): Unrealized gain (loss) on December 31, 20x1

Fair value of call option - July 1 ,20x1 (cost) 10,000

Fair value of call option - Dec. 31, 20x1 (see above) 400,000

Unrealized gain - increase in fair value 390,000

Requirement (c): Net cash settlement on March 31, 20x2

Fixed purchase price (₱220 x 20,000) 4,400,000

Purchase price at current market price (₱250 x 20,000) 5,000,000

Net cash settlement - receipt 600,000

Requirement (d): Realized gain (loss) on March 31, 20x2

March 31, Cash 600,000

20x2 Call option 400,00

Gain on call option (squeeze) 200,000

Alternative solution: (250－240) × 20,000 = 200,000

Illustration 8: Interest rate swap (swap payment at maturity)

On January 1, 20x1 when the current market rate of interest was 10%, ABC Co obtaines a
₱1,000,000, variable rate loan. Interest payments on the loan are due every year-end.

ABC Co. was worried about future fluctuations in interest rates. Thus, on January 1, 20x1, ABC
Co. entered into an interest rate swap wherein ABC Co shall receive interest at whatever the
current market rate of interest is at the beginning of the year and pay fixed interest at 10%.
Swap payment shall be made only on December 31, 20x3, i.e., maturity date.

Case #1:

Requirement (a): Net cash settlement

If the current market rate of interest on January1, 20x3 is 8%, how much is the net cash
settlement at maturity date?. Indicate whether it is receipt or payment.

Solution:

20x1 20x2
Receive variable (at Jan. 1 current rate) 100,000 80,000
Pay 10% fixed 100,00 100,000
Net cash settlement - (payment) (due on Dec. 31, 20x3) - (20,000)
Requirement (b): Fair value of derivative

If the current market rate of interest on December 31, 20x2 is 8%, how much is the fair value of
the interest rate swap?. Indicate whether it is a derivative asset or liability.

Solution:

Net cash settlement - (payment) (due on Dec. 31, 20x3) (20,000)

Multiply by: PV of 1 @8%. n=1 0.9259

Fair value of interest rate swap - liability (18,518)

Case #2:

Requirement (a): Net cash settlement

If the current market rate of interest on January 1, 20x3 is 12%, how much is the net cash
settlement at maturity date?. Indicate whether it is receipt or payment.

Solution:

20x1 20x2
Receivable variable (at Jan. 1 current rates) 100,000 120,000
Pay 10% fixed 100,000 100,000
Net cash settlement - receipt (due on Dec. 31, 20x3) - 20,000

Requirement (b): Fair value of derivative

If the current market rate of interest on December 31, 20x2 is 12%, how much is the fair value
of the interest rate swap?. Indicate whether it is derivative asset or liability.
Solution:

Net cash settlement - receipt (due on Dec. 31, 20x3) 20,000

Multiply by: PV of 1 @12%, n=1 0.8929

Fair value of interest rate swap - asset 17,858

Alternative solution: (12% - 10%) x 1,000,000 x PV of 1 @12%, n=1 = 17,858

Illustration 9: Interest rate swap (periodic swap payments)

On January 1, 20x1, ABC Co obtained a five year, ₱1,000,000 variable-rate loan with interest
payments due at each year-end and the principal due on December 31, 20x5.

As protection from possible fluctuations in current market prices, ABC Co enters into an interest
rate swap for the whole principal of the loan. Under the agreement, ABC Co shall receive
variable interest and pay fixed interest based on a fixed rate of 8%. swap payments shall be
made at each year-end.

The following are the current market rates:

January 1, 20x1 8%

January 1, 20x2 9%

January 1, 20x3 12%

Requirement (a): What is the ‘’notional’’ amount of the interest rate swap agreement?

Answer: ₱1,000,000 - the principal amount of the loan.

Requirement (b): How much is the fair value of the interest rate swap on December 31, 20x1?.
Indicate whether it is a derivative asset or liability.

Solution:
Receive variable (1M x 9%) 90,000

Pay 8% fixed 80,000

Net cash settlement - receipt (due annually for the next 4 years) 10,000

Multiply by: PV ordinary annuity @9%, n=4 3.23972

Fair value of interest rate swap - asset 32,397

Alternative solution: (9% receipt - 8% pay) x 1M x PV ordinary annuity @9%, n=4 = 32,397 asset

Requirement (c): How much is the fair value of the interest rate swap on December 31, 20x2?.
Indicate whether it is derivative asset or liability.

Solution:

Receive variable (1M x 12%) 120,000

Pay 8% fixed 80,000

Net cash settlement - receipt (due annually for the next 3 years) 40,000

Multiply by: PV ordinary annuity @12%, n=3 2.40183

Fair value of interest rate swap - asset 96,073

Characteristics of a derivative

a. Its value changes in response to the change in an underlying;

b. It requires no initial net investment (or only a very minimal initial net investment); and
c. It is settled at a future date.

An “underlying” is a specified price, rate, or other variable.

A “notional amount” is a specified unit of measure.

PROBLEMS

PROBLEM 1: TRUE OR FALSE

1. An increase in prices would result to recognition of a gain in a “short” futures contract.

2. If the market price exceeds the strike price in a put option contract, the option is said to
be in the money.
3. The maximum amount of loss in an option contract that is not designated as a hedging
instrument is equal to the acquisition cost of the option.
4. Dogs Co. acquires an option. At the inception, Dogs Co. pays a deposit to the broker.
The deposit forms part of the carrying amount of the derivative instruments.
5. Howl Co. acquires an option. Howl Co. pays an amount for the option. The payment
forms part of the carrying amount of the derivative instrument.
6. According to PFRS 9, all derivatives shall be measured at fair value.
7. Derivatives that are not designated as hedging instrument are accounted for as held for
trading securities. All subsequent changes in the fair value of the derivative is
recognized in profit or loss.
8. Entity A enters into a foreign country swap. Entity A does not designate the swap as a
hedging instrument. The gain or loss on the measurement of the swap at each reporting
date shall be recognized in profit or loss.
9. Entity X enters into a forward contract to but 1,000 foreign currencies at a forward rate
of P1.00. At the reporting date, the forward rate is P1.50. Entity X will recognize a gain
of P500 on the forward contract.
10. Entity Y enters into a forward contract to buy 1,000 foreign currencies at a forward rate
of P2.00. At settlement date, the spot rate increase to P3.00. On the net settlement of
forward contract, Entity Y receives a net cash payment of P1,000.

PROBLEM 2: FOR CLASSROOM DISCUSSION

Characteristics of derivatives.
1. It is a financial instrument or other contract that derives its value from the changes in
value of some other underlying asset or other instrument.
a. embedded derivative c. derivative
b. financial asset d. all of these
2. Which of the following is not among the characteristics of a derivative.
a. It must have at least two or more notional amounts.
b. Its value changes in response to the change in an underlying.
c. It requires no initial net investment or only a very minimal initial net investment.
d. It is settled at a future date.
3. Which of the following can be an underlying for a derivative?
a. temperature c. interest or exchange rate
b. specified price d. all of these
4. Which of the following can be a notional amount for a derivative?
a. share price c. number of currency units
b. interest rate d. exchange rate
5. Which of the following can be a notional amount for derivative?
a. Number of peso c. bushels of wheat
b. number of shares d. all of these
6. Derivatives are obtained
a. as hedging instrument to hedge some kind of risk
b. for speculation
c. either a of b
d. neither a nor b
7. It is the possibility that an event will occur having an adverse effect on the achievement
of an entity's objectives.
a. Risk c. Insurance risk
b. Financial risk d. Contingency
8. Risk is measured in terms of
a. Impact b. likelihood c. fair value d. a and b
 9. According to PFRS 7, it is risk that the fair value or future cash flows of a financial
instrument will fluctuate because of changes in market prices (other than those arising
from interest rate risk or currency risk), whether those changes are caused by factors
specific to the individual financial instrument or its issuer, or factors affecting all similar
financial instruments traded in the market.
a. Interest rate risk c. Fair value risk
b. Currency risk d. Other price risk
10. It is the risk of possible future change in one or more of 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.
a. Insurance risk c. Financial risk
b. Operating risk d. Credit risk
11. Entity X enters into a forward contract to sell 1,000,000 foreign currency units at a
forward rate of P0.50. At the reporting date and on settlement date, the current rates
are P0.58 and P0.52, respectively. Identify the notional amount and the underlying in
the contract.
Notional amount Underlying
a. P0.50 1,000,000
b. 1,000,000 Foreign currency
c. 1,000,000 Forward rates
d. P0.50, P0.48 and P0.52 1,000,000

Forward contract

12. ABC Co. expects the value of the won to increase in the next 30 days. Accordingly, on
December 15, 20x1, ABC Co. enters into a 30-day forward contract to buy 10,000 wons
at the forward rate of P1.24. On December 31, 20x1, the forward rate was P1.27 and by
January 15, 20x2, the spot rate moved to P1.30.
 Requirements: Provide the journal entries under each of the following scenarios: (a) the
contract is settled by the actual purchase of the foreign currency; and (b) the contract is
settled through net cash payment.

Futures contract

13. On December 1, 20x1, ABC Co. enters into a futures contract to sell 10,000 units of a
commodity on January 31, 20x2 for P100 per unit. The broker requires an initial margin
deposit of P10,000. The quoted prices per unit are as follows:

Dec. 1, 20x1 Dec. 31, 20x1 Jan. 31, 20x2

100 98 97

Requirement : Provide the journal entries

CALL OPTION

14. Drive Co. acquires a call option on 1,000 units of a commodity at a strike price
of P100 for P400 on March 1, 20x1. The call option is exercisable on July 1, 20x1.
The movements in prices are shown below :

Mar. 1, 20x1 June 30,20x1

Spot Prices P100 P120

Time value of option 400 100

Requirements: Provide the journal entries (assume net settlement of the

contract).

Interest rate swap

15. Tuba Co. enters in to “receive variable, pay fixed” interest swap on January 1,
20x1 for a notional amount of P1,000,000. Under the terms of the contract , if
the current rate increases above 12%, Tuba Co. shall pay the deficiency. Swap
payment shall made on December 31, 20x2. The current rates are as follows :

Jan. 1, 20x1…………………………………………………………… 12%

Jan. 1, 20x2………………………………………………………………15%

Requirements: Provide Journal entries.

PROBLEM 3: EXCERCISES

1. On December 1, 20x1, Stair Box Co. enters into a 45-day forward contract to
buy 1,000 kilograms of coffee beans at a forward price of P100 per kilogram. The
market prices in the subsequent periods are as follows:

December 31, 20x1……………………………………………….P285

January 15, 20x2……………………………………………………P245

Requirements: Provide the journal entries under each of the following scenarios:
(a) the contract is settled by the actual purchase of the commodity; and (b) the
contract is settled through net cash payment.

2. On December 15, 20x1, ABC Co. enters into a 30-day forward contract to buy
10,000 yens at the forward rate of P1.50. On December 31, 20x1, the forward rate
was P1.25 and by January 15, 20x2, the spot rate moved to P1.60.

Requirements: Provide the journal entries under each of the following scenarios:
(a) the contract is settled by the actual purchase of yens; and (b) the contract is
settled through net cash payment.
3. On December 1, 20x1, View Co. enters into a futures contract to sell 100,000
foreign currency units on January 31, 20x2 for P100 per unit. The broker requires
an initial margin deposit of P10,000. The current rates are as follows:

Dec. 1, 20x1 Dec. 31, 20x1 Jan. 31, 20x2

100 98 103

Requirement: Provide the journal entries.

4. Brook Co. purchased a put option contract on March 1, 20x1 when Back Yard
Co. shares are trading at P180 per share. The terms of the contract give Brook the
option to sell 1,000 shares of Back Yard stock at a strike price of P180 per share.
The option expires on July 1, 20x1. Brook purchased the call option for P720.

Mar. 1, 20x1 June 30, 20x1

Spot prices 180 120

Time value of option 720 180

Requirements: Provide the journal entries. Assume net settlement of the contract.
5. Kelley Co. purchased a put option on Flynn common shares on July 7, 2004, for
$170. The put option is for 200 shares and the strike price is $50. The option
expires on January 31, 2005. The following data are available with respect to the
out option:

Date Market Price of Flynn Shares Time Value of Put option

September 30, 2004 $54per share. $88

December 31, 2004. $52 per share. 35

January 31, 2005. $55 per share 0

Requirements: Prepare the journal entries.

6. On January 1, 2002, Eden Ventures, Inc., received a three-year, $1 million loan

with interest payments due at the end of each year and the principal to be repaid
on December 31, 2004. The interest rate for the first year is the prevailing market
rate of 9 percent, and the rate each succeeding year will be equal to the
prevailing market rate of Jan 1 on that year. Eden also entered into an interest
rate swap agreement related to this loan. Under the terms of the swap
agreement, in the years 2003 and 2004, Eden will receive a swap payment based
on the principal amount of $1 million. If the January 1 interest rate is greater than
9 percent, Eden will receive a swap payment for the difference; and if the January
1 interest is less than 9 percent, Eden will make a swap payment for the
difference. The swap payments are made on December 31 of each year. On
January 1, 2003, the interest rate is 8 percent, and on January 1, 2004, the
interest rate is 12 percent.

Requirement: Make the journal entries for the interest rate swap on Eden's
books at the dates shown below (assume the interest rate swap is not
designated as a hedging instrument; ignore the hedged item, i.e., loan). For
the purposes of estimating future swap payments, assume that the current
interest rate is the best forecast of the future interest rate (round all entries
to the nearest dollar).
1. January 1, 2002
2. December 31, 2002
 3. December 31, 2003
4. December 31, 2004

7. Hay Co. enters into a “received fixed, pay variable” interest rate swap on July 1,
20x1 for a notional amount of P3,000,000. The set rate is 12%, equal to the
current rate on July 1, 20x3. Cash settlement is due on July 1, 20x3. Information
on market rates follows:

July 1, 20x1…………………………………………..12%
July 2, 20x2…………………………………………..9%
July 1, 20x3……………………………………………13%
Requirements:
a. How much is the derivative asset (liability) to be presented in Hay's June
30,, 20x2 statement of financial position?
b. How much is gain (loss) recognized on settlement date?

PROBLEM 4: CLASSROOM ACTIVIES

1. ABC Co. experts the value of euro to decrease in the next 30 days. Accordingly, on December
15, 20x1, ABC Co. enters into a 30-days forward contract to sell 100,000 euros at the forward
rate of P50,00. On December 31,20x1, the forward rate was P51,00 and by January 15, 20x2 the
spot rate moved to P47,00

Requirements: Provide the journal entries under each of the following scenarios: (a) the
contract is settled by the actual sale of the foreign currency; and (b) the contract is settled
through net cash payment.

2. December 1, 20x1, Golf Co. enters into a futures contracts to sell 100,000 foreign currency
units on January 31, 20x2 for P300 per units. The broker requires an initial margin deposit of
P40,000. The current rates are as follows:

Dec 1, 20x1 Dec. 31,20x1 Jan. 31, 20x2

300 298 297

Requirement: Provide the journal entries.

3. Pathfinder Co. acquires a call option on 10,000 currency units at a strike price of P500 for
P20,000 on April 1, 20x1. The call option is exercisable on July 1, 20x1. Movement in price are
shown below:

Apr. 1, 20x1 June 30, 20x1

Spot Prices P500 P600

Time value of option 20,000 5,000

Requirements: Provide the journal entries (assume net settlement of the contract).

4. On January 1, 20x1, Cedula Co. enters into an interest rate swap for journal amount of
P1,000,000. Under the agreement, ABC Co. shall receive variable interest and pay fixed
interest based on a fixed rate of 14%. The interest rate swap will be settled net on
December 31, 20x2.

The following are the current market rates:

Jan. 1, 20x1 14%

Jan. 1, 20x1 12%

Requirements: Provide the journal entries.

5. On January 1, 20x1, Pink Floyd Co. enters into an interest rate swap for a national amount
of P1,000,000. Under the agreement, Pink Floyd Co. shall receive variable interest and pay
fixed interest based on a fixed rate of 6%. Swap payments shall be made at the end of each
year in the next three years.

The following are the current market rates:

Jan. 1, 20x1 6%

Jan. 1, 20x2 7%

Jan. 1, 20x3 4%

PROBLEM 5: MULTIPLE CHOICE – THEORY

1. Which of the following is not a characteristic of a derivative?

a. It is settled at a future date

b. It derives its value from the changes in value of some other national amount.

c. It requires no initial net investment or only very minimal initial net investment

d. All of these are valid characteristics of a derivative.

2. It is an agreement between two parties to exchange a specified amount of a commodity,

security, or foreign currency at a specified date in the future at a pre-agreed price. It is most
likely an over-the-counter transaction rather that a standardized and traded instrument.

a. Forward contract c. Backward contract

b. Futures contract d. Past’s contract

3. It is a futures contract whereby the holder agrees to sell.

a. “Long” futures contract c. “Big” futures contract

b. “Short” futures contract d. “Shorts pan” futures contract
4. If the strike price in a cell option contract exceeds the current price, the option is
considered.
a. In the money c. At the money
b. Out of the money d. No money, no honey
5. In which of the following instances would the holder of the instrument recognizes gain
when the market rate or price increases?
a. Futures contract where the holder is in the short position.
b. Forward contract to sell foreign currency units
 c. “Receive fixed, pay variable” interest rate swap
d. “Receive variable, pay fixed” interest rate swap
6. In which of the following instances would the holder of the instrument recognizes loss
when the market rate or price decrease?
a. Futures contract where the holder is in the long position.
b. Forward contract to purchase a specified quantity of a commodity.
c. Call option
d. Put option
7. Classic Co. enters into a “short” futures contract during the period. The futures contract
will be settled net in the following period. At the reporting date, Classic Co. recognizes a
gain on the futures contract. Which of the following statements is correct?
a. Classic co.’s current period statement of financial position will include a
derivative liability for the futures contract.
b. Prices have increased.
c. Prices have decreases.
d. A and C
8. In which of the following derivative contract would the investor most likely pay a marginal
deposit (treated as receivable) at the inception of the contract?
a. Forward contract c. Call option
b. Futures contract d. Put option
9. Which of the following derivatives is most likely to be settled on a net cash basis?
a. Forward contract c. Call option
b. Futures contract d. Put option
10. The initial marginal deposit paid to a broker in conjunction with a futures contract is
accounted for by the investor as a.
a. Derivative asset c. Receivable
b. Derivative liability d. Loss

PROBLEM 12-6: MULTIPLE CHOICE – COMPUTATIONAL

1. On December 15, 20x1, ABC Co. enters into a 30-day forward contract to sell 1,000,000 yens
at the forward rate of P1.20. On December 31, 20x1, the forward rate was P1.25 and by January
15, 20x2, the spot rate moved to P1.27.

How much is the gain (loss) recognizes on the forward contract on December 31, 20x1?

a. P50,000 gain c. P20,000 gain

b. P50,000 loss d. P20,000 loss

2. On December 15, 20x1 ABC Co. enters into a 30-day forward contract to buy 1,000,000 yens
at the forward rate of P1.20. On December 31, 20x1, the forward rate was P1.20. and by
January 15, 20x2, the spot rate moved to P1.27.

How much is the gain (loss) recognized on the forward contract on January 15, 20x2?

a. P50,000 gain c. P20,000 gain

b. P50,000 loss d. P20,000 loss

3. On December 15, 20x1, ABC Co, enters into a 30-days forward contract to sell 1,000,000 yens
at the forward rate of P1.20. On December 31, 20x1, the forward rate was P1.25 and by January
15, 20x2 the spot rate moved to P1.27.

How much is the total gain (loss) recognized on the forward contract?

a. P70,000 gain c. P30,000 gain

b. P70,000 loss d. P30,000 loss

4. On October 1, 20x1, Midnight Co. enters into a 60-days forward contract to sell 1,000
kilograms of potatoes at a forward price of P300 per kilogram. The market prices in the
subsequent periods are as follow.

October 31, 20x1…………………………….P285

November 30, 20x1 ………………………… P245

How much is the net cash payment or receipt on the net settlement of the forward contract?
 a. P55,000 payment c. P15,000 payment
b. P55,000 receipt d. P15,000 receipt

5. On December 15, 20x1, Dark Co. enters into a 45-days forward contract to sell 10 tons of
onions at a forward price of P300,000 per ton. The market prices (per ton) in the subsequent
periods are as follows:

December 31, 20x1……………………………………. P290,000

January 31, 20x2 ……………………………………… P312,000

Which of the following will be presented in Dark’s December 31, 20x1 statement of financial
position?

a. P12,000 derivative position c. P100,000 derivative asset

b. P100,000 derivative liability d. None of these

6. ABC Co. expects the value of a foreign currency to decrease in the next 30 days. Accordingly,
on December 15, 20x1, ABC Co. enters into 30-days forward contract to sell 100,000 euros at
the forward rate P60,00. On December 31, 20x1, ABC Co. reported a derivative liability of
P200,000. The forward rate on December 31,20x1 must have been.

a. P58.00 c. P64.00

b. P47.00 d. None of these

7. On December 15, 20x1 ABC Co. enters into a 30-days forward contract to sell 1,000,000
foreign currencies at a forward rate of P0.47. The spot rate on settlement date is P0.45. ABC Co.
recognizes P45,000 gain on the settlement of the forward contract. Which of the following
would have been recognized?

In ABC Co.’s December 31, 20x1 statement of forward position?

a. Derivative assets of P15,000

b. Derivative liability of P15,000
 c. Derivative assets of P25,000
d. Derivative liability of P25,000

8. During the period, an entity acquires a call option for a certain commodity for P10,000. The
strike price is P1M. The option was not designated as a hedging instrument. At the reporting
date, prior to statement, the current price of the related commodity is P1.2M. How much is
carrying amount of the call option in the entity’s end-of-period statement of financial position?

a. 0 c. 200,000

b. 210,000 d. 190,000

9. Mingming Co. paid a premium of P15,000 for call option on 10,000 units of a foreign currency
at a strike price of P500 per unit. The subsequent market prices were P499 at the reporting
date and P498 at exercise date. On expiration date, Mingming Co. recognizes a

a. 20,000 gain c. 10,000 gain

b. 5,000 loss d. 10,000 loss

10. Rome Co. enters into a futures contract to sell 10,000 units of a foreign currency for P100
per unit. The broker requires an initial margin deposit of P20,000. The quoted prices per unit
are as follows.

Dec. 1, 20x1 Dec. 31, 20x1 Jan. 31,20x1

100 98 97

How much is the net cash settlement on the futures contract?

a. 30,000 receipt c. 50,000 receipt

b. 30,000 payment d. 50,000 payment
11. On January 1, 2002, Cougar Company received a two-year $500,000 loan. The loan calls
payment to be made at the end of each year based on the prevailing market rate at
 January 1 of each year. The interest rate at January 1, 2002, was 10 percent. Aggie
Company also has a two-year $500,000 loan, buts Aggie’s loan carries a fixed interest rate
of 10 percent. Cougar Company does not want to bear the risk that interest rates may
increase in year two of the loan. Aggie Company believe that rates may decrease and they
would prefer to have variable debt. So the two companies enter into an interest rate swap
agreement whereby Aggie agrees to make Cougar’s interest payment in 2003 and Cougar
likewise agrees to make Aggie’s interest in 2003. The two companies agree to make
settlement payments, for the difference only, on December 31, 2003. If the interest rate on
December 31, 2002 is 12 percent, what amount will Cougar report as the fair value of the
interest rate swap at December 31, 2001 (answers rounded to the nearest dollar)?
a. $0 c. $10,000
b. $8,929 d. $500,000
12. On June 18, Edwards Corporation entered into a firm commitment to purchase specialized
equipment from the Okazaki Trading Company for ¥80,000,000 on August 20. The
exchange rate on June 18 is ¥100 = $1. To reduce the exchange rate risk that could increase
the cost of the equipment in U.S. Dollars, Edwards pays $12,000 for the call option
contract. This contract gives Edward the option to purchase ¥80,000,000 at an exchange
rate of ¥100 = $1 on August 20. On August 20, the exchange rate is ¥93 =$1. How much did
Edward save by purchasing the call option (answer rounded to the nearest dollar)?
a. $12,000
b. $48,215
c. $60,215
d. Edward would have been better off not to have purchased the call option.
13. On March 1, Chow Corporation entered into a firm commitment to purchase specialized
equipment from the Gifu Trading Company for ¥80,000,000 on June 1. The exchange rate
on March 1 is ¥100 = $1. To reduce the exchange rate risk that could increase the cost of
the equipment in U.S. Dollars, Chow pays $20,000 for call option contract. This contract
gives Chow the option to purchase ¥80,000,000 at an exchange rate of ¥100 = $1. On June
 1. On June 1, the exchange rate is ¥105 to $1. How much did Chow save by purchasing the
call option (answers rounded to the nearest dollar)?
a. $20,000
b. $27,619
c. $47,619
d. Chow would have been better off not to have purchased the call option.
14. On January 1, 2002, Cougar Company received a two-year $500,000 loan, the loan calls for
payments to made at the end of each year based on the prevailing market rate at January 1
of each year. The interest rate at January 1, 2002, was 10 percent. Aggie company also has
a two-year $500,000 loan, but Company does not want to bear the risk that interest rates
may increase in year two of the loan. Aggie Company believes that rates may decrease and
they would prefer to have variable debt. So, the two companies enter in an interest rate
swap agreement whereby Aggie agrees to make Cougar’s interest payment in 2003 and
Cougar likewise agrees to make Aggie’s interest payment in 2003. The two companies
agree to make settlement payments for the difference only, on December 31, 2003. If the
interest rate on January 1,2003 is 8 percent, what will be cougar's settlement payment
to/from Aggie?
a. $5,000 payment c. $10,000 payment
b. $5,000 receipt d. $10,000 receipt
15. On January 1, 2002, Cougar Company received a two-year $500,000 loan. The loan calls for
payments to made at the end of each year based on the prevailing market rate at January 1
of each year. The interest rate at January 1, 2002, was 10 percent. Aggie company also has
two-year $500,000 loan, but Aggie's loan carries a fixed interest rate of 10 percent. Cougar
Company does not want to bear the risk that interest rates may increase in year two of the
loan. Aggie company believes that rates may decrease and they would prefer to have
variable debt. So the two companies enter into an interest rate agreement whereby Aggie
agrees to make Cougar's interest payment in 203 and Cougar likewise agrees to make
Aggie's interest payment in 2003. The two companies agree to make settlement payments,
for the difference only, on December 31, 2003. If the interest rate on January 1, 2003, is 12
percent, what will be Cougar's settlement payment to/from Aggie?
a. $5,000 payment c. $10,000 payment
b. $5,000 receipt d. $10,000 receipt