5.01- Financial Instruments and Derivatives

Question 1

What are the three types of FINANCIAL INSTRUMENTS?

Answer 1

• Cash
• Ownership interests in equity
• Derivative contracts that create a right or obligation

Question 2

How should investments in marketable securities and all derivatives be valued?

Answer 2

Fair market value

Question 3

How should notes and loans receivable or payable be valued?

Answer 3

Amortized cost

Question 4

What are the three reason entities acquire DERIVATIVES?

Answer 4

• Investments
• Arbitage
• Hedging

Question 5

What is ARBITAGE?

Answer 5

The ability to take advantage of price differentials.

potential profitability without the risk

Question 6

What is a HEDGE?

Answer 6

A derivative that reduces or eliminates the risk of price fluctuation.

Question 7

When using a derivative as an investment, what is the primary goal? What is the biggest risk?

Answer 7

• To Gain money

- Losing money

Question 8

What is the primary goal of a HEDGE?

Answer 8

To make sure you do not gain or lose money. (no risk!)

Question 9

Are DERIVATIVES assets or liabilities?

Answer 9

They can be either!

Question 10

What are DERIVATIVES reported at?

Answer 10

Fair value

Question 11

Where are unrealized gains and losses generally recognized for DERIVATIVES? What is the exception?

Answer 11

• Income

- Cash flow hedges are recognized in OCI

Question 12

What are the three CHARACTERISTICS of DERIVATIVES?

Answer 12

(NUNS)

• No net investment
• Underlying and Notional amounts
• net Settlement

Question 13

Why are derivatives considered to have “no net settlement”

Answer 13

There is no real investment being made, since losses are being swapped with gains and gains are being swapped with losses.

Question 14

What is the NOTIONAL AMOUNT?

Answer 14

The number of units.

Question 15

What is the UNDERLYING AMOUNT?

Answer 15

The factor that affects the derivatives value.

Question 16

What is an OPTION CONTRACT?

Answer 16

You have the RIGHT but not the OBLIGATION to pay or sell something in the future at a fixed price now.

Question 17

What is a PUT OPTION?

Answer 17

The right to sell shares

Question 18

What is a CALL OPTION?

Answer 18

The right to buy shares

Question 19

What is a FUTURES CONTRACT?

Answer 19

You have the RIGHT and the OBLIGATION to pay or sell something in the future at a fixed price now.

-Traded on a national exchange

Question 20

What is a FORWARD CONTRACT?

Answer 20

You have the RIGHT and the OBLIGATION to pay or sell something in the future at a fixed price now.

-NOT traded on a national exchange

Question 21

What is an INTEREST RATE or FOREIGN CURRENCY SWAP?

Answer 21

When two counterparties exchange streams of cash flow for a given time.

Question 22

What is OFF-BALANCE SHEET RISK?

Answer 22

The risk that the amount you owe will change.

Question 23

What is CREDIT RISK?

Answer 23

Risk that a loss occurs because another party fails to perform or live up to their contract.

Question 24

What are the three DISCLOSURES that must be made about a DERIVATIVE PARTNER?

Answer 24

• Activity
• Region
• Economic Characteristic

Question 25

What are the three DISCLOSURES that must be made concerning CREDIT RISK?

Answer 25

- Maximum level or credit risk - Policy for requiring collateral or other securities - Arrangements to mitigate the risk

Question 26

What is MARKET RISK?

Answer 26

The risk a loss may occur due to changes in the market due to ECONOMIC CIRCUMSTANCES

Question 27

When a company invests in a derivative purely for gain, what is it called?

Answer 27

SPECULATIVE GAIN

Question 28

What is an example of a privately agreed upon derivative?

Answer 28

INTEREST RATE SWAP AGREEMENT

Question 29

What is CONCENTRATION OF CREDIT risk?

Answer 29

The risk when you depend on many different companies that are affected by common issues.