Chapter 16 Appendix 16A Chapter 16 Appendix 16AHedging Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto

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 act of hedging (to reduce economic and financial risks) from the accounting

3 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 –Under IFRS, two types of hedges identified for hedge accounting – fair value and cash flow hedges –Under ASPE, only certain transactions qualify for optional hedge accounting

4 Optional Hedge Accounting Optional hedge accounting may be 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 reliably measured b.Hedging relationship is reassessed at regular intervals c.If involves forecasted transactions, probable that transactions will occur

5 Hedging Fair Value Hedge –To offset exposure to fair value changes of recognized asset or liability –Under IFRS, hedged item valued at fair value and gains/losses booked to net income Cash Flow Hedge –Offset risks of future cash flow variability –Under IFRS, gains/losses on hedging item reported as part of Other Comprehensive Income –Under PE GAAP, not recognized until the transaction is settled

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

7 Fair Value Hedge - Example Investment (intended for sale) purchased at a cost of: $1,000 Investment (FVOCI)1,000 Cash1,000 Option contract to sell shares at $1,000 purchased for $10 Financial Instrument – Derivative 10 Cash10

8 Fair Value Hedge - Example At year end, assume investment value is $1,050 Journal entry: Investment (FVOCI)50 Gain/Loss50 and Gain/Loss 50 Financial Instrument - Derivative50

9 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

10 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

11 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

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

13 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 using discounted cash flow model Under IFRS, any gain reported as part of Comprehensive Income Value at the end of the swap contract is zero

14 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 Under IFRS, recorded in Other Comprehensive Income Under PE GAAP, not recognized until settled

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