4.2 Derivatives and hedge accounting

Derivatives are financial instruments that derive value from underlying assets or indices. This section explores various types of derivatives, their characteristics, and valuation methods. Understanding these complex instruments is crucial for effective risk management and investment strategies.

Hedge accounting is a specialized accounting method used to align the timing of gains and losses on hedging instruments with the hedged items. This section covers hedge accounting criteria, effectiveness assessment, and the accounting treatment for different types of hedges, including fair value and cash flow hedges.

Derivative Financial Instruments

Types of Derivatives

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• Derivative financial instruments derive value from underlying entity performance (asset, index, or interest rate)
• Four main types of derivatives serve distinct purposes in financial markets
  • Forwards and futures contracts facilitate buying or selling assets at predetermined future prices
    • Futures standardized and traded on exchanges
  • Options grant holders rights to buy (call) or sell (put) assets at specified prices within set timeframes
  • Swaps enable parties to exchange cash flow series (interest rates, currencies)
• Derivatives applications include hedging, speculation, and arbitrage in risk management and investment strategies

Characteristics and Valuation

• Fair value of derivatives influenced by multiple factors
  • Underlying asset price
  • Time to expiration
  • Volatility
  • Interest rates
• Derivative contracts exhibit unique features
  • Leverage allows for significant exposure with minimal initial investment
  • Off-balance-sheet nature impacts financial reporting
  • Complexity requires specialized knowledge for proper valuation and risk assessment
• Valuation methods vary by derivative type
  • Black-Scholes model for options
  • Discounted cash flow analysis for swaps
  • Futures pricing based on spot price and cost of carry

Hedge Accounting Principles

Hedge Accounting Criteria

• Hedge accounting modifies normal basis for recognizing gains/losses on hedging instruments and hedged items
• Three essential criteria for applying hedge accounting
  • Formal designation and documentation of hedging relationship
  • Hedge effectiveness assessment
  • Reliable measurement of hedged item and hedging instrument
• Documentation requirements include
  • Risk management objective and strategy
  • Identification of hedging instrument and hedged item
  • Nature of risk being hedged
  • Method for assessing hedge effectiveness

Hedge Effectiveness Assessment

• Hedge effectiveness measures degree of offsetting changes between hedged item and hedging instrument
• Prospective and retrospective effectiveness tests conducted
  • Inception of hedge (prospective)
  • Ongoing basis (both prospective and retrospective)
• Quantitative methods for measuring effectiveness
  • Dollar-offset method compares changes in fair values or cash flows
  • Regression analysis assesses statistical relationship between variables
• Qualitative assessments applicable for certain hedging relationships
  • Critical terms of hedging instrument and hedged item match (maturity, notional amount)
• Ineffectiveness in hedging relationship measured and recorded in earnings immediately

Fair Value vs Cash Flow Hedges

Fair Value Hedges

• Fair value hedges protect against changes in fair value of recognized assets, liabilities, or firm commitments
• Accounting treatment for fair value hedges
  • Changes in fair value of hedging instrument recognized in earnings
  • Carrying amount of hedged item adjusted for changes in fair value attributable to hedged risk
  • Both changes recorded in same income statement period
• Examples of fair value hedges
  • Interest rate swap to hedge fixed-rate debt (changes in fair value due to interest rate fluctuations)
  • Forward contract to hedge foreign currency denominated receivable (changes in fair value due to exchange rate movements)

Cash Flow Hedges

• Cash flow hedges protect against variability in expected future cash flows
  • Recognized assets or liabilities (variable-rate debt)
  • Forecasted transactions (anticipated sales in foreign currency)
• Accounting treatment for cash flow hedges
  • Effective portion of gain/loss on hedging instrument reported in other comprehensive income
  • Ineffective portion recognized in earnings immediately
  • Amounts in other comprehensive income reclassified to earnings when hedged transaction affects income statement
• Examples of cash flow hedges
  • Interest rate swap to hedge variable-rate debt (stabilize interest payments)
  • Forward contract to hedge forecasted foreign currency sales (lock in exchange rate)

Net Investment Hedges

• Net investment hedges protect against foreign currency exposure of net investment in foreign operation
• Accounting treatment for net investment hedges
  • Effective portion of gain/loss on hedging instrument reported in cumulative translation adjustment within equity
  • Ineffective portion recognized in earnings
• Example of net investment hedge
  • Foreign currency borrowing to hedge net investment in foreign subsidiary

Derivatives and Hedge Accounting Entries

Non-Designated Derivatives

• Journal entries for derivatives not designated as hedging instruments
  • Initial recognition: Record fair value of derivative (if any)
  • Subsequent measurement: Record changes in fair value directly in earnings
• Example entry for non-designated derivative gain:

  Dr. Derivative Asset   XXX
      Cr. Gain on Derivatives   XXX
  

Hedge Accounting Entries

• Fair value hedge entries
  • Adjust carrying amount of hedged item for changes in fair value attributable to hedged risk
  • Record changes in fair value of hedging instrument
• Cash flow hedge entries
  • Record effective portion in other comprehensive income
  • Reclassify amounts to earnings when hedged transaction affects income statement
• Net investment hedge entries
  • Record effective portion in cumulative translation adjustment within equity

Disclosure Requirements

• Qualitative disclosures
  • Entity's objectives and strategies for using derivatives
  • Risk management policies
• Quantitative disclosures
  • Fair values of derivative instruments
  • Gains/losses on derivative instruments and related hedged items
• Location and amounts of derivative instruments and related gains/losses in financial statements
• Specific disclosures for each hedge type
  • Fair value hedges: Effect on income statement and balance sheet
  • Cash flow hedges: Expected reclassification of gains/losses from other comprehensive income
  • Net investment hedges: Cumulative amount of hedging instrument gains/losses in cumulative translation adjustment