Prepared by: Patricia Zima, CA Mohawk College of Applied Arts and Technology Chapter 16A Hedging

2 Derivatives Used For Hedging Organizations face economic and financial risks Derivatives are often used to offset these risks - hedging Hedging generally reduces uncertainty/risk, and therefore volatility, which gives hedging its value Must separate the economics of hedging from the accounting

3 Derivatives Used For Hedging Economics: –Companies enter into transactions to reduce volatility and loss –Losses/gains on hedged items offset by gains/losses on hedging items – no economic loss Accounting: –May need to apply optional, special hedge accounting if gains/losses do not offset in the income statement in same period

4 Derivatives Used For Hedging Symmetry in accounting - if gains/losses offset then no need for special hedge accounting No symmetry in accounting – gains/losses do not offset in same period - may choose to apply hedge accounting so that the gains/losses do offset –Two types of hedges identified for hedge accounting – fair value and cash flow hedges

5 Hedging Fair Value Hedge –To offset exposure to fair value changes of recognized asset or liability –Hedged item valued at fair value and gains/losses booked to net income Cash Flow Hedge –Offset risks of future transactions –Gains/losses on hedging item reported as part of Other Comprehensive Income

6 Optional Hedge Accounting Optional Hedge accounting available when the following are met: 1.When the hedge is entered into a.Identify the exposure b.Designate that hedge accounting applied c.Document risk management objectives and strategies 2.Reasonable assurance should exist that the firms’ risk management policy is being maintained a.Hedge effectiveness can be reasonably measured b.Hedge is reassessed as regular intervals c.If involves forecasted transactions, probable that transactions will occur

7 Put Options as Fair Value Hedge Option to sell an instrument/investment at a pre-determined price Eliminates the risk of a price decrease

8 Fair Value Hedge - Example Investment (intended for sale) purchased at a cost of: $1,000 Journal entry to purchase Investment-available for sale1,000 Cash1,000 Option contract entered into

9 Fair Value Hedge - Example At year end, assume investment value is $1,050 Journal entry: Investment – Avail. for sale50 Gain on Investment50 and Loss on Investment 50 Derivative-trading 50

10 Fair Value - Put Option - Example Under hedge accounting gain is recorded on the hedged item through net income Loss is recorded on the underlying derivative The gain is offset by the loss on the derivative Hedge accounting allows for a modifying of the way we normally account for available for sale investments

11 Cash Flow Hedge - Examples Interest rate swaps used as hedges Similar in nature to forward contracts Requires two parties to enter into Payments are made under a fixed or floating rate of interest Payments then made by the second party –Terms are the opposite of the original payment terms

12 Interest Rate Swap Party A Party B FinancialIntermediary A pays B at a fixed (or floating) rate B pays A using the opposite rate of A

13 Interest Rate Swap Given: Jones enters into a 5-year interest rate swap with B Terms are: Jones will make payments at the fixed rate of 8% Jones will receive payments at variable or floating rates Principal sum involved is $1,000,000

14 Interest Rate Swap Value of the swap determined at the end of each year –Function of the difference between the fixed (contract) rate and the prevailing rate of interest Value of the swap contract reported on the Balance Sheet at fair market value Any gain reported as part of Comprehensive Income Value at the end of the swap contract is zero

15 Forward Contract as a Cash Flow Hedge Forwarding contracts may be used to hedge anticipated future transactions (and the associated cash flow risks) i.e. a purchase commitment Gives the holder the right to purchase at a preset price Unrealized gains or losses on hedging item are recorded in Other Comprehensive Income When gains/losses are realized, they are transferred from OCI to NI –Gain or loss arises when the spot price is different than the forward (contract) price

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