Module 19: Derivative Instruments and Hedging Activities

Question 1

Exclusion from Derivative Instruments

Answer 1

• Normal purchases and sales
• Equity securities
• Debt securities
• Regular-way (three-day settlement) security trades
• Leases
• Mortgage-backed securities
• Employee stock options
• Royalty agreements and other contracts tied to sale volumes
• Variable annuity contracts
• Adjustable rate loans
• Guaranteed investment contracts
• Nonexchanged traded contracts tied to physical variables
• Derivatives that serve as impediments to sales accounting (e.g. guaranteed residual value in a leasing arrangement)

Question 2

Inclusions In Derivative Instruments

Answer 2

• Options to purchase (cal) or sell (put) exchange-traded securities
• Future Contracts
• Interest rate swaps
• Currency swaps
• Swaptions (an option on a swap)
• Credit indexed contracts
• Interest rate caps/floors/collars

Question 3

Fair Value Hedges

Answer 3

A fair value hedge is the use of a derivative instrument to hedge the exposure to changes in the fair value of an asset or a liability.

Question 4

Bifurcation

Answer 4

The process of separating an embedded derivative from its host contract. This process is necessary so that hybrid instruments (a financial instrument or other contract that contains an embedded derivative) can be separated into their component parts, each being accounted for using the appropriate valuation techniques.

Question 5

Notional Amount

Answer 5

The notional amount (or payment provisions) is the referenced associated asset or liability. A notional amount is commonly a number of units such as shares of stock, principal amount, face value, state value, basis points, barrels of oil, etc. It may be that amount plus a premium or minus a discount.

Question 6

IFRS - Derivative

Answer 6

A derivative is a financial instrument that (1) requires little or no initial investment, (2) changes in value in response to a change in the value of another instrument or index (called an underlying), and is settled in the future.

Question 7

IFRS - Hedge Instrument

Answer 7

A hedging instrument is a type of derivative that is classified as a fair value hedge, a cash flow hedge, or a hedge of a net investment in operations.

Question 8

Derivative

Answer 8

Derivatives are financial instruments that derive their value from changes in a benchmark (an underlying) based on stock prices, interest rates, currency rates, commodity prices, or some other agreed-upon financial or physical variable that has observable or objectively verifiable changes.

Question 9

Disclosures related to financial statements

Answer 9

Disclosures related to financial statements, both derivative and non-derivative, that are used as hedging instruments , must include the following information, (1) objectives and the strategies for achieving them, (2) content to understand the instrument, (3) risk management policies, and (4) a list of hedged instruments. These disclosures have to separated by type of hedge and reported every time a complete set of financial statements is used.

Question 10

At the money

Answer 10

An at-the-money option is one in which the price of the underlying is equal to the strike or exercise price.

Question 11

Call Option

Answer 11

An American call option provides the holder the right to acquire an underlying at an exercise or strike pice, anytime during the option term. A premium is paid by the holder for the right to benefit from the appreciation in the underlying.

Question 12

Derivative instruments

Answer 12

Derivative instruments are defined by their three distinguishing characteristics. Specifically, derivative instruments are financial instruments or other contracts that have:

1) One or more underlings and one or more notional amounts (or payment provisions or both);
2) No initial net investment or a smaller net investment than required for contracts expected to have a similar response to market changes; and
3) Terms that require or permit:
a. Net settlement
b. Net settlement by means outside the contract
c. Delivery of an asset that results in a position substantially the same as net settlement.

Question 13

Hedging Instruments - General Criteria

Answer 13

Two primary criteria must be met in order for a derivative instrument to qualify as a hedging instrument.

a. Sufficient documentation myst be provided at the beginning of the process to identify at minimum (1) the objective and strategy of the hedge, (2) the hedging instrument and the hedged item, and (3) how the effectiveness of the hedge will assessed on an ongoing basis.
b. The hedge must be “highly effective” throughout its life.

Question 14

Cash Flow Hedge

Answer 14

Cash flow hedges use derivative instruments to hedge the exposure to variability in expected future cash flows.

Question 15

Discount or premium on a forward contract

Answer 15

The foreign currency among of the contract multiplied by the difference between the contracted forward rate and the spot rate at the date of inception of the contract.

Question 16

Embedded derivative

Answer 16

A feature on a financial instrument or other contract, which if the feature stood alone, would meet the definition of a derivative.

Question 17

Fair Value

Answer 17

Defined as the amount at which the asset or liability could be bought or settle in an arm’s length transaction; measured by reference to market prices or estimated by net present value of future cash flows, options pricing models, or by other techniques.

Question 18

Firm Commitment

Answer 18

An agreement with an unrelated party, binding on both, usually legally enforceable, specifying all significant terms and including a disincentive for nonperformance sufficient to make performance likely.