Flashcards in F5 Financial Instruments & Derivatives Deck (28):
Name 3 Financial Instruments COD
O=Ownership Interest in an entity (stock)
D=Derivative Contracts (stock options)-->Creates a right & obligation to transfer other financial instruments
a contract whose value is based on another contract or an underlying index
3 reasons for investments in derivatives (ASC 815)
1. Investments - high risk investment, like stock options
2. Arbitrage - take advantage of price differentials in separate markets
3. Hedge - use derivative to reduce risk
3 characteristics of derivatives N.UN.S
1. No net investment
2. Underlying & Notional amount
3. Net settlement
Factor that affects value, like price, interest rate, exchange rate
# of units (LBs, Bushels, Units)
Required disclosures of Derivatives
1. Credit risk & Max amt of loss
2. Activity, region, economic characteristic of each Concentration
3.Policy of requiring collateral
4. Policy used to mitigate credit risk
5.If/Why FMV can't be estimated
Risks associated with derivatives are called __
Off BS Risk - due to possible changes in amounts owed
Optional derivative disclosure
Market risk - loss may occur due to changes in FMV
Where are Derivative Disclosures recorded in F/S
the F/S Notes
1 similarity b/t Futures Contract and Forward Contract
Both give you the Right & Obligation to Buy
1 difference b/t Futures Contract and Forward Contract
Futures price is set Today; Forward price is set at End of Contract
explain Call Option contract
a derivative, Right only (NOT Obligation) to BUY in the future
explain Put Option contract
a derivative, Right only (NOT Obligation) to SELL in the future
define the Perfect Hedge
-Eliminates risk entirely &
-No possibility of future gain/loss
2 types of GAAP Hedges
1. Fair Value Hedge
2. Cash Flow Hedge
Define Fair Value Hedge
A hedge designed to mitigate/eliminate risk associated with an exposure to changes in fair value. It's a Derivative hedging against a Recognized Asset/Liability OR a Firm Purchase Commitment
**Changes in value are recognized in IS
Define Cash Flow Hedge
Hedging against a Forecasted Transaction (not a legal commitment)
**Changes in value are recognized in OCI ("D"ENT)
Which hedge is unique to IFRS?
Hedges of Net Investment in Foreign Ops (treat like Cash Flow hedge)
What is the Intrinsic Value of a stock (call/buy) option?
(Market Value - Strike Price) * # of shares = Intrinsic Value of stock option
Strike Price = Exercise Price
How should gains or losses from fair value hedges be recognized?
The gain or loss, along with the offsetting loss or gain attributable to the hedged risk, is recognized on the I/S in earnings in the same accounting period.
What's the purpose of an interest rate swap?
An interest rate swap is designed to convert a variable rate loan payable into a fixed rate when anticipating increases in interest rates OR vice versa, to convert a fixed rate to a variable rate anticipating interest rate decreases.
Which risks are inherent in an interest rate swap agreement?
1. the risk of exchanging a lower interest rate for a higher rate
2. risk the counterparty will not be able to make payments to settle differentials.
Explain concentration of credit risk
When an entity's customers share common characteristics such that an event adversely affecting the ability of one to pay also affects the abilities of others to pay.
e.g. customers in same industry & industry takes a downward turn will adversely impact the ability of related customers to pay the entity
What type of risk is this? Company B disclosed in the notes of the F/S that a significant number of its unsecured trade A/R are with companies in the same industry.
Concentration of credit risk
*must be disclosed in the notes of the F/S
What risk exists when an entity has multiple assets that are valued on the basis of similar market criteria, such as interest rate?
Concentration of Market Risk
Explain Risk of measurement uncertainty
The inability to estimate uncollectible accounts with reasonable accuracy.
Could be due to lack of experience to draw conclusions from.