Derivatives Introduction

Question 1

What is a derivative?

Answer 1

A financial instrument with all three of the following:

1. ) It has one or more underlyings and one or more notional amounts
2. ) Requires no initial net investment
3. ) Its terms require or permit a net settlement.

Question 2

What is an “underlying amount?”

Answer 2

A specified price, rate or other variable

Question 3

What is a “notional amounts?”

Answer 3

A specified unit of measure on which a derivative is valued (e.g. 10,000 bushels)

Question 4

What is a settlement amount in relation to derivatives?

Answer 4

Derived by the multiplication of the notional amount by the underlying. E.g. shares of stock times the price per share.

Question 5

What are some examples of Derivatives?

Answer 5

1. ) Option Contracts
2. ) Futures Contracts
3. ) Forward Contracts
4. ) Swap Contracts
5. ) Contracts with characteristics comparable

Question 6

What is an option contract?

Answer 6

A stock option that requires maker to deliver shares of stock at a later time in exchange for a fixed option price.

Question 7

What is a futures contract?

Answer 7

Made through a clearinghouse (e.g. to deliver or receive a commodity or foreign currency in the future at a set price set at the present)

Question 8

What is a forward contract?

Answer 8

Not made through a clearinghouse. Like a futures contract, but made directly between contracting parties

Question 9

What is a swap contract?

Answer 9

An agreement to exchange currencies, debt securities, etc.

Question 10

How are derivatives reported?

Answer 10

Must be recognized as either an asset or liability and measured at fair value

Question 11

How is a hybrid contract (Host contract with an embedded derivate) accounted for?

Answer 11

The embedded derivative should be separated from the host contract and accounted for as a separate derivative instrument if:

1. ) The economic characteristics and risks of the derivative are not clearly and closely related to the contract
2. ) The hybrid instrument is not remeasured to fair value each year
3. ) As a separate instrument, the embedded instrument would meet the requirements of a derivative.

Question 12

When an embedded derivative is separated from its host contract, how is it allocated for measurement purposes?

Answer 12

1. ) The derivative is initially recorded at its fair value
2. ) The difference between the carrying value of the hybrid contract and the fair value of the derivative element is the initial value of the remaining host contract

Question 13

What is the initial entry to record a derivative (not intended to hedge)?

Answer 13

Dr: Investment in Derivative

CR: Cash

Question 14

When a derivative changes in fair value, what is the subsequent recognition?

Answer 14

1. ) Adjust the carrying value of the derivative to current fair value (increase/decrease asset or liability)
2. ) Recognizing the related gain or loss in current income

Question 15

What is hedging?

Answer 15

A risk management strategy that involves offsetting transactions or positions so that a loss on one transaction or position would be offset (at least in part) by a gain or another transaction or position