Exam Reviewer (4th)

Question 1

Which of the following is not a condition for hedge accounting?
(a) Formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge at inception of the hedging relationship.

(b) The hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk, the effectiveness of the hedge can be reliably measured, and the hedge is assessed on an ongoing basis and determined actually to have been effective.
(c) For cash flow hedges, a forecast transaction must be highly probable and must present an exposure to variations in cash flows that could ultimately affect profit or loss.
(d) The hedge is expected to reduce the entity’s net exposure to the hedged risk, and the hedge is determined actually to have reduced the net entity-wide exposure to the hedged risk.

Answer 1

The hedge is expected to reduce the entity’s net exposure to the hedge risk, and the hedge is determined actually to have reduce the net entity- wide exposure to the hedge risk.

Question 2

Which of the following is not a distinguishing characteristic of a derivative instrument?

• Terms that require or permit net settlement
• One or more underlying or notional amount
• No initial net investment
• Must be ‘highly effective’ throughout its life.

Answer 2

Must be ‘highly effective’ throughout its life.

Question 3

Although forwards have terms that are not standardized, the clearinghouse of that exchange still takes the opposite position of each trade, thereby protecting the counterparties from default risk.

Answer 3

False

Question 4

When a call option on a future is exercised, the seller receives a short position in the underlying future plus pays cash to the holder of the option.

Answer 4

True

Question 5

The market value of a financial derivative is primarily a function of the relative demand and supply for that contract.

Answer 5

False

Question 6

Although minimal, arbitragers face the risk of the market value of the underlying asset declining by an amount greater then what was protected with the hedge.

Answer 6

False

Question 7

Which of the following statements accurately describes how futures contracts differ from forward contracts?

• All of these choices are correct
• Future contracts are standardized
• Future contracts require a daily settling of gain and losses
• The performance of counterparties to a future contract is guaranteed by a clearing house

Answer 7

All of these choices are correct

Question 8

All of the following are characteristics of a derivative except:

• It is acquired or incurred by the entity for the purpose ofgenerating a profit from short-term fluctuations in market factors.
• Its value changes in response to the change in a specifiedunderlying (e.g., interest rate, financial instrument price,commodity price, foreign exchange rate, etc.).
• It requires no initial investment or an initial net investment thatis smaller than would be required for other types of contracts thatwould be expected to have a similar response to changes in marketfactors.
• It is settled at a future date.

Answer 8

It is acquired or incurred by the entity for the purpose of generating a profit from short-term fluctuation in the market factors

Question 9

Techniques such as hedging, forward contracts and options can:

Answer 9

Reduce Risk

Question 10

Which of the following is not a derivative instrument?

a. Futures contracts.
b. Credit indexed contracts.
c. Interest rate swaps.
d. Variable annuity contracts.

Answer 10

d. Variable annuity contracts.

Question 11

If an oil wholesaler expects to buy some gasoline for his customers in the future and wants to hedge his risk, he needs to:

• sell gasoline now
• do nothing
• sell a crude oil futures contract.
• buy a crude oil futures contract.

Answer 11

buy a crude oil futures contract.

Question 12

Which type of contract is unique in that it protects the owner against unfavorable movements in the prices or rates while allowing the owner to benefit from favorable movements?

• option
• forward contract
• interest rate swap
• future contract

Answer 12

Option

Question 13

On February 1, Shoemaker Corporation entered into a firm commitment to purchase specialized equipment from the Okazaki Trading Company for ¥80,000,000 on April 1. Shoemaker would like to reduce the exchange rate risk that could increase the cost of the equipment in U.S. dollars by April 1, but Shoemaker is not sure which direction the exchange rate may move. What type of contract would protect Shoemaker from an unfavorable movement in the exchange rate while allowing them to benefit from a favorable movement in the exchange rate?

• Call option
• Interest rate swap
• Forward contract
• put option

Answer 13

Call option

Question 14

Which of the following is the characteristic of a perfect hedge?

• the possibility of future gain and no future loss
• no possibility of future gain only
• no possiblity of future gain or loss
• no possibility of future loss only

Answer 14

no possiblity of future gain or loss

Question 15

In exchange for the rights inherent in an option contract, the owner of the option will typically pay a price

• at the time the option is recieved regardless of whether the option is exercise or not.
• only when the put option is exercised.
• when either the call option and put option is exercised.
• only when the call option is exercised.

Answer 15

at the time the option is recieved regardless of whether the option is exercise or not.

Question 16

An interest rate swap in which company has fixed rate of interest and pays a variable rate is called a:

• hedge of foreign currency exposure of net investment in foreign operation
• deferred hedge
• cashflow hedge
• fair value hedge

Answer 16

fair value hedge

Question 17

A company enters into a futures contract with the intent of hedging an account payable of DM400,000 due on December 31. The contract requires that if the U.S. dollar value of DM400,000 is greater than $200,000 on December 31, the company will be required to pay the difference. Alternatively, if the U.S. dollar value is less than $200,000, the company will receive the difference. Which of the following statements is correct regarding this contract?

• the contract obligate the company to pay if the value of U.S dollar increases
• The future contract is a contract to buy Deutsche marks at a fixed rate
• the Deutsche mark futures contract effectively hedge against the effect of exchange rate exchangeson the U.s dollar value of the Deutsche mark payable.
• the future contract is a contract to sell Deutsche mark at a fixed rate.

Answer 17

the future contract is a contract to sell Deutsche mark at a fixed rate.

Question 18

If a farmer expects to sell his wheat in anticipation of a harvest and wants to hedge his risk, he needs to:

• buy wheat future contracts now
• buy wheat now
• sell wheat now
• sell wheat future contracts now

Answer 18

sell wheat future contracts now

Question 19

Arnold Co. purchased a call option on the rice field of Robert Co. on January 1, 200A exercisable on or before January 1, 200B. On December 31, 200A, the fair market value of the rice field was below the call option price, making the instrument “out of the money,” and Arnold Co. decided not to exercise the call option. Which of the following statements is correct?

• the call option does not meet the definitionof a derivative under PFRS’s regarding settlement at a future date
• the call option does not meet the definition of a derivative; however, it should be written off on December 31, 200A, and a corresponding financial liability should be recognized.
• the call option meets the definition of a derivative under PFRS’sregarding settlement at a future date since expiry at a maturity is a form of settlement even though there is no additional exchange of consideration.

Answer 19

the call option meets the definition of a derivative under PFRS’sregarding settlement at a future date since expiry at a maturity is a form of settlement even though there is no additional exchange of consideration.

Question 20

On January 1, 200A, Clifton Co. enters into a forward contract to purchase 10,000 shares of stock from Jane Co. on December 31, 200A at a forward price of ₱100 per share. Clifton Co. prepays the shares at ₱100 per share which is the current price of the shares on January 1, 200A. Which of the following is correct?

Answer 20

the forward contract fails the ‘no initial net investment or an initial net investmentthat is smaller than would than would be required for other types of contract that would be expected to have a similar response to changes in market factors’ test for a derivative.

Question 21

The “risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation”.

Answer 21

Credit risk.

Question 22

The “risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices”.

Answer 22

Market risk

Question 23

The “risk that an entity will encounter difficulty in meeting obligations associated with financial liabilities that are settled by delivering cash or another financial asset”.

Answer 23

Liquidity risk

Question 24

The “risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices (other than those arising from interest rate risk or currency risk), whether those changes are caused by factors specific to the individual financial instrument or its issuer, or factors affecting all similar financial instruments traded in the market”.

Answer 24

Other price risk

Question 25

The “risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in foreign exchange rates”.

Answer 25

Currency risk

Question 26

A contract traded on an exchange that allows an entity to buy or sell a specified quantity of commodity or a financial security at a specified price on a specified price on a specified future date.

Answer 26

Futures contract

Question 27

A contract that gives the holder the right, but not the obligation, to buy or sell an asset at a specified price any time during a specified period in the future.

Answer 27

Option

Question 28

A contract in which two parties agree to exchange payments in the future based on the movement of some agreed-upon price or rate.

Answer 28

Swap

Question 29

Agreement between two parties to exchange a specified amount of a commodity, security, or foreign currency at a specified date in the future at a pre-agreed price.

Answer 29

Forward contract