Manual Introduction to Derivative Financial Instruments: Bonds, Swaps, Options, and Hedging

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Accounting for Derivatives explains the likely accounting implications of a proposed transaction on derivatives strategy, in alignment with the IFRS 9 standards. Written by a Big Four advisor, this book shares the author's insights from working with companies to minimise the earnings volatility impact of hedging with derivatives. This second edition includes new chapters on hedging inflation risk and stock options, with new cases on special hedging situations including hedging components of commodity risk.

Derivatives

This new edition also covers the accounting treatment of special derivatives situations, such as raising financing through commodity-linked loans, derivatives on own shares and convertible bonds. Cases are used extensively throughout the book, simulating a specific hedging strategy from its inception to maturity following a common pattern. Coverage includes instruments such as forwards, swaps, cross-currency swaps, and combinations of standard options, plus more complex derivatives like knock-in forwards, KIKO forwards, range accruals, and swaps in arrears.

Under IFRS, derivatives that do not qualify for hedge accounting may significantly increase earnings volatility. Compliant application of hedge accounting requires expertise across both the standards and markets, with an appropriate balance between derivatives expertise and accounting knowledge. This book helps bridge the divide, providing comprehensive IFRS coverage from a practical perspective.

Learn new standards surrounding the hedge of commodities, equity, inflation, and foreign and domestic liabilities.

Derivatives Basics | Types of Derivatives | FAQs | BSE

Risks associated to projected profit payoffs must be well understood before the product is offered to the customer or launched in the market. It is highly unadvisable to guesstimate the return.


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An option is an agreement between a buyer and a seller that, when exercised, gives the former the right, but not the obligation, to require the option writer seller to perform cer- tain specified obligations. The price a buyer pays to a seller for an option is its premium, meant to compensate the seller for his or her willingness to grant the option. The price at which the option can be exercised is the strike price. The last day on which an option can be exercised, or off- set, is the expiration date.

An option is exercised at the sole discretion of the buyer who will tend to act only when it is in his interest to do so. The put option holder can make a profit if prices decline, while limiting his loss to the money paid as premium if the asset increases in value. Futures and forwards are different types of instruments, as they may require the holder to buy or sell an underlying asset at some time in the future.

Unlike an option, the holder cannot simply let the contract lapse. Futures are current commitments that can be exercised, as their name implies, in the future. They are traded in exchanges and have a market, except of course in the case of panic. Futures take the form of contracts in which the quantity of the underlying and expiration date are standardized. Forwards are not traded on exchanges; they are over-the- counter OTC instruments, essentially bilateral agreements that have no active market.


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While superficially they might seem similar to options, inas- much as they entail the obligation to deliver or take delivery on a specified expiration date of a defined quantity of an underlying— and do so at a price agreed on the contract date—forwards and futures can involve major risks because of the leverage they make possible. In an interest rate swap, one counterparty pays the other a fixed rate of interest based on some variable rate of interest.

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The latter changes as market interest rates change. Traders often look at the swap as a portfolio of forward con- tracts, one for a cash payment date and each written at the same forward price. For instance, a swap can be used to offset the risk of an uncovered position, seeing to it that there is a future cash flow that would move in the opposite direction to that of a hedged position. At least theoretically, swapping cash streams from assets enables companies and investors to turn one type of asset or liabil- ity into a different one, as well as to execute a number of other bilat- eral transactions.

This statement is also valid for many other instruments. Swaps are also made with commodities. Like the interest rate swaps, a commodity swap is a financial contract between two parties that effectively fixes the price of an asset for a period of time. The parties typically agree to the length of the swap, settlement period s within the swap, quantity of the commodity swapped per settle- ment period, and fixed price of the commodity.

A market currently in the upside is that of credit risk swaps. A credit risk swap is a plain-vanilla version of credit derivatives3 whereby the protection buyer pays the protection seller a fixed recur- ring amount in exchange for a payment contingent upon a future credit event; for instance, bankruptcy.

DERIVATIVES - Forwards, Futures, Options, Swaps [Explained with EXAMPLES]

In exchange for this premium: If that event takes place, Then the protection seller must pay the agreed compensation to the protection buyer. Depending on the amount involved in the credit swap, this helps to cover part or all of credit loss pursuant to default. By trans- ferring credit risk from protection buyer to protection writer, credit default swaps have opened up new opportunities for trading and other business transactions.

These instruments, which as counter- party agreements involve their own credit risk, help in price dis- covery. Options on caps, floors, and swaps give the purchaser the right, but not the obligation, to buy or sell the underlying instruments. Swaptions are basically options on other derivatives, also known as compound options.

Current and future challenges with derivative financial instru- ments are not so much associated to products that have become commodities but to the so-called exotics. The latter are innovative and complex instruments, very difficult to price the right way, and involve too many unknowns whose aftereffects are revolutionizing the banking industry. Exotic derivatives are products of rocket scientists Chapter 1 who see to it that the name and nature of these derivatives steadily change. Therefore, for supervisors, bankers, and investors, a better way than naming the instrument itself is to classify a derivatives trans- action as exotic by the fact that its price and underlying are linked by a nonlinear function.

As we saw in the preceding section, this function may exhibit chaotic characteristics. Breaking such barriers usually results in steep changes in the payoff function, which are most difficult to foretell. Good management practice requires that prior to making bets on exotic derivatives, it is necessary to develop not only good understanding but also reliable price monitoring and measurement techniques. Without them, one should never invest in the multitude of exotics offered in the market.

A similar policy should be followed with synthetic and structured derivative instru- ments as discussed in the following sections. In conclusion, short of adequate preparation, proper staffing, and full understanding of risk and return, the most likely outcome will be a torrent of red ink. As exotics are becoming the instrument of choice in financial engineering, losses suffered by many corporate treasurers, pension fund managers, bankers, and investors have been recently hitting the headlines.

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If the reader wishes to retain a valuable message from this section, it would be that he or she needs to really appreciate that custom-made and exotic derivatives are bringing with them a host of new learning requirements and associated expo- sures. Without the ability to make these instruments reveal their risks, and to do so before commitment, exotics can be deadly because the doors of risk and return are adjacent and indistinguishable.

This, however, is not the majority opinion. According to the international financial reporting standards IFRS , a synthetic instrument is a financial product designed, acquired, and held to emulate the characteristics 4 Economist, London, June 4, Such is the case of a floating-rate long-term debt combined with an interest rate swap. Because the synthetic short sale seeks to take advantage of price disparities between call and put options, it tends to be more prof- itable when call premiums are greater than comparable put premi- ums. The holder of a synthetic short future will profit if gold prices decrease and incur losses if gold prices increase.

A synthetic put seeks to capitalize on disparities between call and put premiums. Basically, synthetic products are covered options and certifi- cates characterized by identical or similar profit and loss structures when compared with traditional financial instruments, such as equities or bonds synthetic options are discussed in Chapter 9, and synthetic futures in Chapter Basket certificates in equities are based on a specific number of selected stocks.

A covered option involves the purchase of an underlying asset, such as equity, bond, currency, or other commodity, and the writing of a call option on that same asset. The writer is paid a premium, which limits his or her loss in the event of a fall in the market value of the underlying.

The concept underpinning synthetic covered options is that of duplicating traditional covered options, which can be achieved by both purchase of the underlying asset and writing of the call option. Moreover, synthetic covered options do not contain a hedge against losses in market value of the underlying. A hedge might be emulated by writing a call option or by calculating the return from the sale of a call option into the product price.

The option premium, however, tends to limit possible losses in the market value of the underlying.

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Derivative

This pre- sents a sense of diversification over a range of risk factors. Region certificates are derived from a number of indexes or companies from a given region, usually involving developing countries. Basket certificates are derived from a selection of companies active in a certain industry sector. An investment in index, region, or basket certificates funda- mentally involves the same level of potential loss as a direct invest- ment in the corresponding assets themselves.


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Their relative advan- tage is diversification within a given specified range; but risk is not eliminated. Moreover, certificates also carry credit risk associated to the issuer. Also available in the market are compound financial instru- ments, a frequently encountered form being that of a debt product with an embedded conversion option. An example of a compound financial instrument is a bond that is convertible into ordinary shares of the issuer. These should be characterized by practically the same terms, albeit without a con- version option.

Embedded derivatives are an interesting issue inasmuch as some contracts that themselves are not financial instruments may have financial instruments embed- ded in them. This is the case of a contract to purchase a commodity at a fixed price for delivery at a future date. Contracts of this type have embedded in them a derivative that is indexed to the price of the commodity, which is essentially a derivative feature within a contract that is not a financial deriva- tive.