Nanyang Technological University

Nanyang Business School

AC3102 Risk Reporting and Analysis

Semester 1, 2019-20

Outline for Seminars 10

Derivatives and Hedge Accounting Part I

Learning Objectives:

Derivatives

• Discuss the key features of Derivatives

o Options
o Forwards

• Discuss the use of Derivatives

• Examine the accounting for Derivatives

Hedge Accounting Part I

• Discuss the use of Hedging for risk management

o Analyse the economic consequences of Hedging

• Discuss the overview of Hedge Accounting

o The need for Hedge Accounting
o Design of Hedge relationships
o Hedge Accounting SFRS(I) 9 vs SFRS(I) 1 - 39

Pre-seminar Activities:

• Review recorded lecture

o 10A Accounting for Derivatives
o 10B Hedge Accounting Part I

• Read

o TLK Ch 10

o SFRS(I) 9
o SFRS(I) 1 – 39

o LKW

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Seminar Questions:

Question 1 - Futures

Suppose it is June 20x8. Suppose you expect that the price of Commodity X to decrease over the
next 3 months. Commodity X futures are traded on an exchange on typical 3-month cycles.

Suppose that you have $10,000 to invest.

Current spot price = $3.00 per kg
Contract size = 5,000 kg
Initial margin = 10%

(a) What would you do to take advantage of your expectation?

(b) Suppose that the price of Commodity X decreases to $2.25 per kg over the next 3 months.
What is the net gain in $ and % given your action in (a)?

(c) Suppose that the price of Commodity X increases to $3.50 per kg over the next 3 months.
What is the net loss in $ and % given your action in (a)?

(d) Explain the feature of a derivative as demonstrated by the results in (b) and (c). Also,
identify that feature to the characteristic of a derivative in the relevant SFRS.

(a)

(b)
Net gain
=

% gain
=

2
(c)
Net loss
=

% loss
=

(d)

Question 2 - Option

An option has a time-value of $0.80.

Its strike price is $8.30. The spot price of the underlying stock is $8.80.

(a) What is the option’s premium if it is a:

(i) Call option?
(ii) Put option?

(b) Why are the premiums different?

(a)
(i) Call option

(ii) Put option

(b)

3
Question 3 – Strategies with Derivatives

The current market price of AIS Ltd’s share is $5.00 per share per share, and a three-month call
option for 10,000 AIS Ltd’s shares at a strike price of $5.00 costs $2,500.

Assume that you have $50,000 to invest, you are contemplating to either:
(a) Buy 10,000 AIS shares, costing $50,000; or
(b) Buy 20 contracts of call option, costing $50,000.

What would be your gain/loss under each of the investment strategies if the market price of AIS
Ltd’s shares at the end of the three-month period when you have to liquidate your investment is:
(i) $5.50 per share; and
(ii) $4.50 per share.

Comment on the difference in gain/loss under each investment strategy.

(i) $5.50 per share

Strategy (a):

Strategy (b):

(ii) $4.50 per share

Strategy (a):

Strategy (b):

Comments:

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Question 4 - Option

On 1 December 20x8, when M2 shares were traded at $6.40 per share, A Ltd purchased a put
option written by B Ltd, for speculative purposes, with the following terms:
• Notional amount: 10,000 of M2 shares
• Exercise price: $6.20
• Expiry date: 31 January 20x9
• Premium: $0.50 per share

(a) Show the journal entry to record the put option on 1 December 20x8 for A Ltd and B Ltd.

(b) Assuming that on 31 December 20x8 the M2 shares are traded at $6.50 per share and the
time value for the put option is $0.20 per share, calculate the fair value (i.e., the intrinsic
value and time value) of the put option for A Ltd and B Ltd, and show the relevant journal
entries for A Ltd and B Ltd.

(c) Assuming that on 31 January 20x9 the M2 shares are traded at $5.50 per share, show the
relevant journal entries to record the net settlement of the put option for A Ltd and B Ltd.

(in $)

(a) A: Dr Derivative asset

Cr Cash

B: Dr Cash
Cr Derivative liability

(b) Intrinsic value =

Time value =
Fair value =

A: Dr Loss (P/L)
Cr Derivative asset

B: Dr Derivative liability
Cr Gain (P/L)

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(c) Intrinsic value =
Time value =
Fair value =

A: Dr Derivative asset
Cr Gain (P/L)

Dr Cash
Cr Derivative asset

B: Dr Loss (P/L)
Cr Derivative liability

Dr Derivative liability
Cr Cash

Question 5 - Forward

A Ltd’s functional currency is S$. It adopts a 31 December accounting year-end and prepares
quarterly financial statements.

On 2 January 20x9, A Ltd enters into a forward exchange contract to sell RM100,000 for
delivery on 30 September 20x9. The exchange rate between S$ and RM are as follows (quoted
as RM 1 = S$xxx).

Interest rate is 4% per annum (which may be ignored in this case).

Forward Rate to
Spot Rate 30 September 20x9
2 January 20x9 0.35 0.30
31 March 20x9 0.38 0.32
30 June 20x9 0.32 0.27
30 September 20x9 0.23 0.23

(a) Calculate the changes in the fair value of the forward contract on 31 March 20x9, 30
June 20x9, and 30 September 20x9.

(b) Show the journal entries on 31 March 20x9, 30 June 20x9, and 30 September 20x9.

(c) Split the changes in fair value of the forward contract into their spot element and
interest/forward element on 31 March 20x9, 30 June 20x9, and 30 September 20x9.
(This split may be required for hedge accounting purposes.)

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(a)
Notional Rate Forward Fair value of Δ FV of forward
amount contracted rate to forward contract contract
Date RM for 30/09/x9 (S$) (S$)
02/01/x9 100,000 0.30 0.30
31/03/x9 100,000 0.30 0.32
30/06/x9 100,000 0.30 0.27
30/09/x9 100,000 0.30 0.23

(b) (in S$)

31/3/x9 Dr Loss*
Cr Derivative liability

30/6/x9 Dr Derivative asset/liability

Cr Gain*

30/9/x9 Dr Derivative asset

Cr Gain

Dr Cash
Cr Derivative asset

(* may be accounted for in P/L or OCI depending on the purpose of the Derivative)

(c)
Δ in
FV of Δ FV of FV of Δ in FV interest/
Notional Forward forward forward spot of spot forward
amount Spot rate to contract contract element element element
Date RM rate 30/09/x9 S$ S$ S$ S$ S$

02/01/x9 100,000 0.35 0.30

31/03/x9 100,000 0.38 0.32

30/06/x9 100,000 0.32 0.27

30/09/x9 100,000 0.23 0.23

Δ in interest/forward element = Δ FV of forward contract – Δ in spot element.

Chong-KW Oct-2019