FINANCIAL INSTRUMENTS,

DERIVATIVES AND HEDGE

ACCOUNTING
BY
UCHE UWALEKE PhD

Lecture Objective
Understand

key financial

instruments
Learn how derivatives could be
used as Hedging instruments
Be familiar with the main
requirements of IFRS 9 with
regard to Hedge Accounting

Presentation Outline
INTRODUCTION
MONEY

MARKET INSTRUMENTS
CAPITAL MARKET INSTRUMENTS
FINANCIAL DERIVATIVES
HEDGE ACCOUNTING PRINCIPLES
CONCLUSIONS

INTRODUCTION
Financial Instruments can be
divided into two broad groups
namely:
Money market instruments
Capital market instruments

MONEY MARKET
INSTRUMENTS
Treasury

Bills (TBs)- short term

borrowing instruments of the fed
issued through the central bank.
Certificate of Deposits (CDs)promissory note issued by a
bank in form of a certificate
entitling the bearer to receive
interest.

.... Money market

Instruments
Commercial Papers (CPs)- short term
unsecured promissory note issued by large
companies and financial institutions at a
discounted value on face value.
Bankers Acceptance (BAs)- a bill of
exchange drawn by a person and accepted
by a bank. A buyers promise to pay to the
seller a certain specified amount at certain
date guaranteed by the banker of the buyer.

...Money market
Instruments
Repurchase

Agreements (Repos)transactions or short-term loans

in which two parties agree to sell
and repurchase the same
security.

Capital Market
Instruments
Common

Stock/Equities/Ordinary
shares- certificates are legal
documents that evidence
ownership in a company
Preferred Stock/Shares enjoy
prior claims over the ordinary
shareholders and carry a fixed
rate of dividend.

...Capital Market
Instruments
Debentures

and Bonds- Interest

bearing debt instrument.
Convertibles- Securities that can
be converted to ordinary shares.

DERIVATIVES
Derivatives refer to a broad class of
instruments which derive their value from
the price of the underlying asset.
In the case of commodity derivatives,
underlying asset can be wheat, gold, oil etc.
For financial derivatives, it can be stock,
currency etc.
The focus of this section is on financial
derivatives

Financial Derivatives
Forward

Contract- An agreement
between two parties to buy or
sell an asset in future. The price
which is paid/received by the
parties is decided at the time of
entering into the contract.
See Illustration

...Financial Derivatives
Futures-

a standardized forward
contract to buy or sell the
underlying asset at a specified
price in the future through an
organized Exchange.
There are margin requirements to
provide safeguard.
See illustration

...Financial Derivative
Options

Contract- An option is a
right but not the obligation to buy
or sell something at a stated date
and specified price.
A call option gives one the right
to buy; a put option the right to
sell.
See Illustration

...Financial Derivatives
Swap

Contract- an agreement
between parties, called
counterparties, to exchange
streams of cash flows over a
period of time in the future

...Financial DerivativesParticipants
Hedgers-

use derivatives to
reduce the risk associated with
the price of an asset.
Speculators- bet on future
movements in the price of an
asset with a view to making
profit.
Arbitrageurs- take advantage of
a discrepancy between prices of

Hedge Accounting
IAS

39 and IFRS 9 deal with all

financial assets and liabilities
including derivatives.
The basic principle is that all
derivatives are carried at fair
value with gains and losses
captured in the income
statement.

...Hedge Accounting- Fair Value

The fair value of a financial asset or liability
is the amount for which the financial asset
could be exchanged or the financial liability
settled between knowledgeable, willing
parties in an arms length transaction.
Underlying this concept of fair value is the
presumption that an entity is a going
concern

...Hedge AccountingCriteria
The

item being hedged must be

identified and designated at the
inception of the hedge.
The hedging instrument must be
identified and designated at the
inception of the hedge.

...Hedge AccountingCriteria
The

effectiveness of the hedge

must be tested regularly
throughout its life.
Effectiveness must fall within a
range of 80% - 125% over the
life of the hedge

...Hedged items
The

hedged item can be an asset

or liability and must expose the
entity to risk of changes in fair
value.
These risks include equity price
risk, foreign currency risk,
interest rate risk etc

...Hedging Instrument
Most

derivative financial
instruments may be designated
as hedging instruments provided
they are with an external party.
An entitys own equity
instruments do not qualify

...Discontinuing Hedge
Accounting

Hedge accounting ceases when

any of the following occurs:
A hedge fails an effectiveness
test
Hedged item is sold or settled
Hedging instrument is sold,
terminated or exercised

... Accounting Entries

Three types of Hedge Accounting are
recognized by IFRS 9
Fair value Hedge
Cash flow Hedge
Net Investment in a foreign operation
See illustrations for specific accounting
treatment of these hedging relationships

Conclusions
Financial instruments are either short term
or medium to long term known as money or
capital market instruments respectively.
Financial derivatives can be used as
hedging instruments.
The basic principle of IFRS 9 is that all
derivatives are carried at fair value with
gains and losses recognized in the income
statement in the period in which they arise.

THE END

Thanks for your attention