2011 Annual Report Financial Supplements - BDO

NOTES TOFINANCIAL STATEMENTSDECEMBER 31, 2011, 2010 AND 2009(Amounts in Millions of Philippine Pesos, Except Per Share Data or As Indicated)2.07 Derivative Financial Instruments and Hedge AccountingBDO Unibank Group is a party to various foreign-currency forward and swap contracts andcross-currency and interest rate swaps. These contracts are entered into as a service tocustomers and as a means of reducing or managing BDO Unibank Group’s foreign exchangeand interest rate exposures, as well as for trading purposes.Derivatives are initially recognized at fair value on the date on which derivative contract isentered into and are subsequently measured at their fair value (except for the embeddedderivatives in CLNs linked to ROP bonds which BDO Unibank Group reclassified to loans).Fair values are obtained from quoted market prices in active markets, including recent markettransactions, and valuation techniques, including discounted cash flow models and optionpricing models, as appropriate. All derivatives are carried as assets when fair value is positiveand as liabilities when fair value is negative.The best evidence of the fair value of a derivative at initial recognition is the transaction price(the fair value of the consideration given or received) unless the fair value of the instrument isevidenced by comparison with other observable current market transactions in the sameinstrument or based on a valuation technique whose variables include only data fromobservable markets. When such evidence exists, BDO Unibank Group recognizes profit orloss at initial recognition.For more complex instruments, BDO Unibank Group uses proprietary models, which usuallyare developed from recognized valuation models. Some or all of the inputs into these modelsmay not be market observable, and are derived from market prices or rates or are estimatedbased on assumptions. When entering into a transaction, the financial instrument isrecognized initially at the transaction price, which is the best indicator of fair value, althoughthe value obtained from the valuation model may differ from the transaction price. Thisinitial difference in fair value indicated by valuation techniques is recognized as profit or lossdepending upon the individual facts and circumstances of each transaction and not later thanwhen the market data becomes observable.The value produced by a model or other valuation technique is adjusted to allow for a numberof factors as appropriate, because valuation techniques cannot appropriately reflect all factorsmarket participants take into account when entering into a transaction. Valuation adjustmentsare recorded to allow for model risks, bid-ask spreads, liquidity risks as well as other factors.Management believes that these valuation adjustments are necessary and appropriate to fairlystate financial instruments carried at fair value in the statement of financial position.Certain derivatives embedded in other financial instruments are considered as separatederivatives when their economic characteristics and risks are not closely related to those of thehost contract and the host contract is not carried at fair value through profit or loss. Theseembedded derivatives are bifurcated from the host contracts and are measured at fair valuewith changes in fair value recognized in profit or loss (except for the embedded derivatives inCLNs linked to ROP bonds which were not bifurcated from the host contracts and werereclassified to loans as permitted for prudential reporting).