Risk and Accounting Financial Instruments: basic definitions and derivatives Marco Venuti 2018
Agenda Overview Definition of Financial Instrument Definition of Financial Asset Definition of Financial liability Definition of Equity Instrument Definition of Derivative Compound Instrument Appendix: kinds of derivatives Pagina 2
Overview IAS 32: Presentation Definition Financial Instruments: Financial Asset, Financial Liability, Equity Instrument, Derivative IAS 39: Recognition and measurement Recognition Measurement Derivatives and Hedge accounting Derecognition IFRS 7: Disclosures Disclosures (Information on financial risks at paragraphs 31-42). IFRS 9 Financial instruments (effective 1 January 2018) Recognition Measurement Derivatives - Hedge accounting - Derecognition
Outside the Scope Certain financial instruments are excluded from the scope of IAS 32For instance: Interests in subsidiaries (IAS 27) Interests in associates (IAS 28) Interests in joint ventures (IFRS 11) Lease rights and obligations (IAS 17/IFRS 16) except for: Finance lease payables of a lessee which are subject to the requirements of IAS 39/IFRS 9
Definition of Financial Instrument A financial instrument is a contract that gives rise to both: a financial asset of one entity & a financial liability or equity instrument of another entity An entity classifies financial instruments: upon initial recognition in accordance with the substance of the contractual arrangement and the definitions of financial assets, financial liabilities and equity instruments into: financial assets,, financial liabilities and equity instruments (issued).
Definition of Financial Asset and Liability Financial asset Cash Equity instrument of another entity Contractual right to receive cash or another financial asset or to exchange financial assets or financial liabilities under potentially favourable conditions Certain contracts settled in the entity s own equity Financial liability Contractual obligation to deliver cash or another financial asset or to exchange instruments under potentially unfavourable conditions Certain contracts settled in the entity s own equity
Definition of Equity Equity Contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities Discussion points: 1) What is the difference between financial liability and equity issued? 2) What is the difference between a financial item and a non-financial items? Examples of non-financial items: Commodities such as silver, oil, wheat and other goods Plant and equipment Broadcast rights Aircraft and ships Real estate
A question for you: Financial instruments Which of the following items are financial instruments? Trade payables Forward exchange contract Patents and trademarks Trade receivables Bonds issued Bonds payable Tax liability Finance lease liabilities Put or call option If they are financial instruments, are they financial assets, financial liabilities or equity instruments?
A question for you Assess the classification (financial liability, equity) of the following financial instruments in the financial statements of the issuer Ordinary shares Redeemable preference shares Irredeemable preference shares with compulsory dividends Preferred shares with discretionary dividends Perpetual bonds (which provide the holder with the contractual right to receive payments on account of interest at fixed dates extending into the indefinite future)
Interest, dividends, losses and gains Classification of a financial instrument issued determines treatment of Interest, dividends, losses and gains related to the instrument Recognise in profit or loss Recognise directly in equity The classification of financial instrument as a financial liability or an equity instrument determines whether interest, dividends, losses and gains relating to that instrument are recognised as income or expenses in profit or loss. Normally the contractual component called interest is recognised as income or expense.
Derivative definition Value changes in response to the change in the underlying Requires little or no initial net investment Settled at a future date Derivative financial instruments create rights and obligations that have the effect of trasferring between the parties to the instrument one or more of ht financial risks inherent in an underlying primary financial instruments. 11
Embedded derivatives What is an embedded derivative? A component of a hybrid contract that also includes a nonderivative host, with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative Example: equity linked note An equity linked note is an instrument whose return is determined by the performance of a single equity security, a basket of equity securities, or an equity index An embedded derivative is a hybrid contract that includes a non-derivative host with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative. An embedded derivative causes some or all of the cash flows that otherwise would be required by the contract to be modified according to a specified interest rate, financial instrument price, 12 commodity price, foreign exchange rate, index of prices or rates
A question for you Assess the classification (financial liability, equity or compound instrument) of the following financial instruments in the financial statements of the issuer 1) equity kicker : Venture capital entities providing subordinated loans agree that if and when the borrower lists its shares on a stock exchange, the venture capital entity is entitled to receive shares of the borrowing entity free of charge or at a very low price (an equity kicker ) in addition to the contractual payments; 2) «equity index linked note»: case of a note linked to an equity index; 3) promissory note : a financial instrument that contains a written promise by one party to pay another party a definite sum of money; 4) Fixed Interest Subordinated Bond : A fixed interest bond pays a specified rate of interest that does not change over the life of the instrument. A subordinate bond is a security that ranks below other loans or securities with regard to claims on assets in case of issuer default p.s. A note is a financial security that generally has a longer term than a bill but a shorter term than a bond
Examples of derivatives and underlyings Type of contract Interest rate swap Main variable Interest rate Exchange rate forward Foreign exchange rate Commodity option Commodity price Credit default swap Credit risk Purchased stock call or put option Forward rate agreement Equity price Interest rate
A question for you: Derivatives Which of the following items are derivatives? A spot contract to exchange 10 millions euro for dollars at the spot rate A contract to exchange 10 millions euro for dollars at a specified forward rate on a specified future date A right to sell 10 millions at a specific date for a specific price for which the company paid a premium Forward contract on the price of gold
Appendix Kinds of Derivatives (possible hedging products ): forward/future Option Different kinds of options Interest rate derivatives Foreign risk and derivatives
Kinds of Derivatives Products can be divided into two categories : 1) Forward Fundamentally, forward and futures contracts have the same function: both types of contracts allow people to buy or sell a specific type of asset at a specific time at a given price Forward Tailor made Future Standardized They can be applied to any tipe of risk
Kinds of Derivatives 2) Options An option is a financial derivative (a derivative because the price of an option is intrinsically linked to the price) that represents a contract sold by one party (the option writer) to another party (the option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed price (strike price) during a certain period of time or on a specific date (exercise date) at a set price (premium). The favorable difference between the strike price and the market price, if any, is the option s intrinsic value. Intrinsic value is positive or zero. Specifically, options are contracts that grant the right, but not the obligation to buy or sell an underlying asset as forward does. They can be applied to any tipe of risk
Different kinds of options Plain Vanilla Call options give the option to buy at certain price Different point of view : the trader buyer would want the stock to go up, the hedger (import side) don t want the stock to go up An option writer (trader) who sells a put option believes that the underlying stock's price will drop relative to the option's strike prce during the life of the option, as that is how he will reap maximum profit. Please note that selling option in front of a certain gain you could have impredicable loss An hedger don t sell an option at all, because in front of certain gain (premium) he has not coverage.
Different kinds of options Plain Vanilla Put options give the option to sell at certain price Different point of view : the trader buyer would want the stock to go down, the hedger (export side) don t want the stock to go down An option writer (trader) who sells a put option believes that the underlying stock's price will increase relative to the option's strike price during the life of the option, as that is how he will reap maximum profit. Please note that selling an option in front of a certain gain you could have impredicable loss An hedger don t sell an option at all, becouse in front of certain gain (premium) he has not coverage
Different kinds of options Combination of plain vallilla option most common zero cost collar A collar is a protective options strategy by purchasing an outof-the-money put (or call import side) option and simultaneously writes an out-of-the-money call option (or put import side) with the same premium. Collars are often used when call (or put) are deemed too expensive.
Relationship between Strike Price and Market Price Call Option Put Option Strike price = Market price At the money At the money Strike price less than market price Strike price greater than market price In the money Out of themoney Out of themoney In the money The relationship between the strike price and the market price is important because it is one determinant of an option s premium.this relationship also determines how the option s value is likely to change given a change in the underlying commodity price (the option s delta)
exotic option Exotics An exotic option is an option that differs in structure from plain vanilla option in terms of the underlying asset, or the calculation of how or when the investor receives a certain payoff. Types of exotic options include: chooser option, barrier options, Asian options, digital options, and compound options, among others. Barrier options are similar to plain vanilla calls and puts, but only become activated or extinguished when the underlying asset hits certain price levels. These options are commonly traded in the foreign exchange and equity markets. These exotic options also come in four types: upand out, down and out, up and in, and down and in. Asian Options are options whose payouts depend on the average price of the underlyng asset over a specific period, generally, the life of the option. These options fall under two broad categories: Average Price Options: The payoff at maturity is equal to the average price of the underlying asset over a period minus the fixed strike price for the option. Average Strike Options: The payoff is equal to the price of the underlying asset at maturity minus a variable strike, which is equal to the average price of the underlying asset over a period.
Option premium As mentioned above, the total cost (the price) of an option is called the premium. This price is determined by different factors including the stock price, strike price, time remaining until expiration (time value) and volatility, interest rate. Because of all these factors, determining the premium of an option is complicated and largely beyond the scope of this class.
Interest rate derivatives Forward: A Forward Rate Agreement (FRA) is an over the counter agreement between two parties, similar to a futures contract, to lock in an interest rate for a short period of time. The period is typically one month or three months, beginning at a future date. A borrower buys an FRA to protect against rising interest rates, while a lender sells an FRA to protect against declining interest rates. Interest Rate Swap (IRS) is an agreement between two parties to exchange their respective cash flows. Most commonly, this involves a fixed rate payment exchanged for a floating rate payment. Both parties are obligated by the swap s conditions. Three month or six month LIBOR are common benchmark floating rates. IRS could be been as a group of FRAs.
Interest rate derivatives Option Interest rate options include caps, floors, and collars used to protect against different reference interest rates or prices of underlying assets. A cap is a series of interest rate options to protect against rising interest rates. In exchange for cap premium, the cap buyer is protected from higher rates (above the cap strike rate) for the period of time covered by the cap. Swapoption are options on interest rate swaps. They give the swaption buyer the right, but not the obligation, to enter into an interest rate swap with predetermined characteristics at or prior to the option s expiry paying a premium
Calculating a FRA Settlement Amount A company needs to borrow $10 million in three months time. Management is concerned that rates may rise, so the company buys a 3 x 6 FRA at 4.00 percent. The term 3 x 6 indicates that the FRA term begins three months from the trade date and ends six months from the trade date (a term of three months). If interest rates have risen (as measured by the reference rate compared with the FRA rate), the bank will compensate the company. If the reference rate has fallen, the company will compensate the bank. FRA rate 4.00% Reference (actual) 5.00% rate Difference 1.00% (1.00% x 90 days/360 daysa x $10 million = $25,000) Since the settlement amount is usually paid at the beginning of the period covered by the FRA, the amount is discounted and its present value paid ($24,691.36) to the company.
Foreign risk and derivatives Forward (as Interest rate differential) A foreign exchange forward is a customized contract that locks in an exchange rate for the purchase or sale of a predetermined amount of currency at a future delivery date. The forward price reflects the difference in interest rates between the two currencies over the period of time covered by the forward. The interest rate differential may be positive or negative, resulting in a for ward price that is at a premium or discount to the spot rate. By locking in an exchange rate, the organization has eliminated the potential for adverse currency movements, but it has also given up the potential for favorable movements. For this reason it could be preferable hedge with Option (call, put, collar, barrier) Cross Currency Swap (CCS) Currency swaps enable swap counterparties to exchange payments in different currencies, changing the effective nature of an asset or liabili ty without altering the underlying exposure. Currency swaps usually have periodic payments between the counterparties for the term of the swap and cover a longer period of time than foreign exchange swaps. A currency swap might be useful for a company that has issued longterm foreign currency debt to finance capital expenditures.
Foreign Exchange Collar A company needs protection against a rising U.S. dollar (declining Euro) six month from now. The current exchange rate is 1.0700 /$. The company enters into a zero cost collar with its bank by purchasing a callusd/put eur option with a strike price of 1.05 /$ and selling a put option with a strike price of 1.0900 /$. Both options are European style with the same six month expiry dates. There are three potential scenarios. If the exchange rate moves above 1.0900 CAD/USD, the company will exercise the call option and buy U.S. dollars at 1.0500. The sold put option will expire worthless. Alternatively, if the exchange rate moves above 1.0900, the bank will exercise the sold put option and the company will be required to buy U.S. dollars from the bank at 1.0900. The company s call option will expire worthless. If the exchange rate remains between 1.0500 and 1.0900, neither option will be exercised, both will expire worthless, and the company s U.S. dollar requirements will be purchased at current market rates.
Commodities derivatives (oil, jet fuel, electricity, natural gas, coal) Forward: Commodities Swap enable hedgers to swap production or consumption prices against the return on an index or another market. The index is often an average price of the fixxing commodities price in the previous month, so it is an agreement between a buyer and a seller to exchange the differential beetwen a predetermined price and the average on a future delivery date The price of a commodity for future delivery differs from the cash price by an amount known as the basis. The basis consists of carrying charges associated with owning the commodity, such as storage, interest charges on money borrowed to buy the commodity, and insurance. The basis may be positive or negative. In a normal or contango market, the forward or futures price is higher than the cash price to accommodate the cost of carrying (owning) the commodity from the trade date to delivery. Included in this cost are financ ing costs, insurance, and storage costs. When demand for the commodity for immediate delivery is high, market participants push up prices for near term delivery. A backwardation or inverted market is one that exhibits higher prices for near term delivery than for longer term delivery. The basis represents a source of risk in commodity hedging
Commodities derivatives (oil, jet fuel, electricity, natural gas, coal) Option: Commodity options may have as their underlying either a physical commodity or a futures contract.