Understanding derivatives and their challenges
Read time: 6 mins
Service: Capital markets
Whether it’s deciding where to invest funds, what kind of insurance contracts to take, or how to increase cash generation, they all involve taking both financial and economic risks. One way to manage these risks is by using derivatives.
What are they?A derivative is a form of financial instrument or other contract whose value is linked to an underlying financial instrument or asset/liability such as a share, bond, index, or commodity. Generally, derivatives are used by companies to protect themselves against adverse fluctuations in the value of an asset or liability. i.e. reducing the risk of potential loss. However, they can also act as a tool to transfer financial risk from one party to another party who considers themselves better equipped to manage the risk.
Types and characteristicsOne of the most difficult tasks in accounting for derivatives is to identify which financial instruments meet the definition of a derivative. The following characteristics can help in identifying derivative contracts:
a. Their value changes in response to a change in:
- a specified interest rate
- financial instrument price
- commodity price
- foreign exchange rate
- index of prices or rates
- credit rating or credit index, or
- another variable.
c. They are settled at a future date.
The most common types of derivative include: forward contracts, future contracts, call options, put options, and swap contracts.
A forward contract is an agreement between two counterparties to buy or sell a financial instrument at a specified price and at a specified future date.
An option contract gives the owner the right, but not the obligation, to buy or sell an underlying asset or financial instrument at a set price on or before a specified date.
A futures contract commits the buyer to purchase an asset or financial instrument and/or a seller to sell an asset or financial instrument at an agreed price at a future date. These are standard contracts which specify the value in the contract, and are traded on an exchange. These contracts can be attached to various underlying assets including currency, oil, gas, and various other commodities.
A swap contract gives one party the right to exchange the cash flow generated from their financial instrument for the cash flow generated from the other party’s financial instrument. The most commonly used swap contracts are Interest Rate Swaps (IRS), including fixed and floating IRS, where one party agrees to exchange their fixed interest rate payment on a loan with another party for their variable interest rate payment on a loan over a similar term.
Accounting for derivativesOnce an entity decides to use derivatives, its management needs to establish a strategy to ensure that the risks are managed properly and that the desired outcomes are achieved. In addition, they should make sure that their derivative accounting policies meet accounting requirements.
Determining the appropriate accounting policies will depend on whether the derivatives are held for speculative purposes or used as a risk management instrument. If they are used for risk management purposes then the entity will have an accounting policy choice to apply hedge accounting, as long as certain criteria are met.
Normal accounting rules mean gains and losses on hedging instruments may not be matched against those arising on hedged items, resulting in earnings volatility. Hedge accounting allows an entity to reduce this volatility and better reflect its risk management processes. It is applied voluntarily provided certain criteria are met.
If the criteria are not met, the entity chooses not to apply hedge accounting or the derivatives are held for speculative purposes, then the derivatives should be initially recognised at fair value. Subsequently, the derivatives should be re-measured at the end of each reporting period and the resulting gains or losses recognised in Profit or Loss.
Hedge accounting – an overviewIf the entity is able to apply hedge accounting then it will need to designate the derivative as a qualifying hedging instrument. Any changes in the fair value will be recognised according to the designation of the hedge and type of hedging relationship, as set out in the terms and conditions of the contract.
There are three types of hedging relationships :
Fair value hedge
A fair value hedge is a hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss.
Cash flow hedge
A cash flow hedge is a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all, or a component of, a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction, and could affect profit or loss.
Derivatives designated as cash flow hedges are generally used for hedging an entity’s exposure to the variability in cash flows arising from changes in prices, foreign exchange rates and also exposure to the variability in the interest cash flows of a floating rate interest-bearing asset and liabilities arising from changes in interest rates.
Hedges of a net investment in a foreign operation
Hedging the foreign currency risk associated with a net investment in an overseas operation is defined in IAS21 The Effects of Changes in Foreign Exchange Rates as a hedge of the reporting entity’s interest in the net assets of that operation.
Common challenges and how to mitigate themChanges in IFRSs and updates to hedge accounting requirements have led many companies to think that their hedge management has been simplified. However, those that have implemented these changes have found them to be something of a challenge.
Measuring derivatives at fair value
Counterparties (i.e. banks) are often unwilling to share information relating to the inputs, assumptions and models used to generate year end valuations which may be required for audit purposes. As a result, entities using derivative instruments will either need to perform the valuations themselves or outsource them.
Developing a hedge accounting programme
One of the biggest challenges faced by any entity
in adopting hedge accounting, is to create a hedge accounting programme. This programme should be created at the inception of the hedging relationship and involve the following steps:
- Developing a risk management policy that describes exposure to the financial risks and procedures to manage these risks;
- Setting out the types of derivatives to be used, how they will value them, and details of the derivative transactions executed in their programme; and
- Setting out the risk management objectives and ensuring that these are monitored so that they are achieved regularly.
Risk management policyA risk management policy must be developed at the start of the hedging relationship to designate the derivative for hedge accounting. This should include:
- risk management objectives;
- details of the exposure that’s being hedged;
- the derivative instruments being used;
- the types of hedge accounting relationships; and
- the reasons for any ineffectiveness that can arise in the hedging relationship.
Other challengesApplying a hedge accounting programme can prove to be costly, with ongoing monitoring of hedges and qualifying hedges being particularly expensive.
Entities should provide thorough training to staff in this complex area. Investing in a simple-to-use system and hedge accounting tools will not only reduce the operational risks associated with using Microsoft Excel for the preparation of manual workings, but will also assist with testing outputs. In addition, using such tools means that more than one person can manage the process and reduce the dependency on key personnel. However, outsourcing hedge accounting to a consultant may be more effective and cost efficient. Consultants may be the right choice if an entity lacks the resource and capability to manage all of this themselves.