FAR 48 - Intro to Derivatives and Currency Hedging Flashcards Preview

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Flashcards in FAR 48 - Intro to Derivatives and Currency Hedging Deck (16):
1

Assume Instco acquires an option to buy (a call option) 100 shares of Opco for $50 per share when the market price of Opco is $45 per share and that Instco paid a premium of $1.00 per share to acquire the options. Which one of the following is the total notional amount related to Instco's options?
A. 100 shares.
B. $5,000.00
C. $4,500.00
D. $100.00

A. Stock options are derivatives; they derive their value from the value of the stock to which the option applies. The notional amount of a derivative is a specified unit of measure, in this case the total number of options (100) acquired by Instco. The specified price of those options would be the underlying.

2

A derivative financial instrument is best described as:
A. Evidence of an ownership interest in an entity such as shares of common stock.
B. A contract that has its settlement value tied to an underlying notional amount.
C. A contract that conveys to a second entity a right to receive cash from a first entity.
D. A contract that conveys to a second entity a right to future collections on accounts receivable from a first entity.

B. A contract that has it settlement value tied to an underlying notional amount best describes a derivative financial instrument. The value or settlement amount of a derivative is the amount determined by the multiplication (or other arithmetical calculation) of a notional amount and an underlying. Simply put, a derivative instrument is a special class of financial instrument which derives its value from the value of some other financial instrument or variable.

3

Which one of the following is not a characteristic of a derivative?
A. A derivative is a financial instrument or similar contract.
B. A derivative requires contractual satisfaction by delivery of the subject matter of the contract.
C. A derivative identifies a specific price, rate, or other monetary measure.
D. A derivative identifies a specific quantity or other quantitative unit of measure.

B. A derivative does not require contractual satisfaction by delivery of the subject matter of the contract. Specifically, the terms of a derivative require or permit the contract to be settled with cash or an asset readily convertible to cash, in lieu of physical delivery of the subject matter of the contract. In addition, a derivative includes an underlying, a notional amount, and requires no initial net investment or one that is less than normally would be required.

4

Which of the following is the characteristic of a perfect hedge?
A. No possibility of future gain or loss.
B. No possibility of future gain only.
C. No possibility of future loss only.
D. The possibility of future gain and no future loss.

A. Hedging is a risk management strategy which involves making an investment (the hedge) so as to offset (or counter) another investment (the hedged item) so that a loss on one investment (the hedged item) would be offset (at least in part) by a gain on the other investment (the hedge), and vice versa. A perfect hedge is achieved when the hedge investment has a 100% inverse correlation to the initial investment (hedged item) so that there is no possibility of future gain or loss. A perfect hedge rarely exists.

5

Assume Instco acquires an option to buy (a call option) 100 shares of Opco for $50 per share when the market price of Opco is $45 per share and that Instco paid a premium of $1.00 per share to acquire the options. Which one of the following is the underlying related to Instco's options?
A. 100 shares.
B. $1.00 per option.
C. $45.00 per option.
D. $50.00 per option.

D. Stock options are derivatives; they derive their value from the value of the stock to which the option applies. The underlying of a derivative is a specified price, rate, or other monetary variable, in this case the (strike) price of each option, $50.00.

6

Smythe Co. invested $200 in a call option for 100 shares of Gin Co. $.50 par common stock, when the market price was $10 per share. The option expired in three months and had an exercise price of $9 per share. What was the intrinsic value of the call option at the time of initial investment?

$100
The intrinsic value of a call option is the difference between the exercise (strike) price and the market price. This call option has an exercise price of $9 / share and the market price is $10 / share. Therefore, there is a $1 / share intrinsic value (I can buy the stock at a price less than the market). The option is to purchase 100 shares so the total intrinsic value is $100.

7

T/F: A forward exchange contract for currencies is a derivative instrument.

True

8

T/F: A stock option is a derivative instrument.

True

9

T/F: Derivative instruments cannot be used for hedging purposes.

False.
For accounting purposes, derivative financial instruments that meet certain criteria may be used as hedges of the risks associated with certain economic undertakings and account balances.

10

T/F: Cash is a derivative instrument.

False.
It is not.

11

T/F: A normal sales contract is a derivative instrument.

False.
It is not.

12

T/F: Reporting derivatives at fair value will result in gains/losses.

True

13

T/F: A derivative notional amount is a specified price or rate.

False.
A notional amount is a specified unit of measure.
A underlying is a specified price, rate, or other variable.

14

What are the two basic kinds of risks that can be hedged for accounting purposes?

Fair value risks and cash flow risks

15

Which one of the following is an item for which risk associated with the item cannot be hedged for accounting purposes?
A. Foreign currency risk of a net investment in a foreign operation.
B. Fair value of an investment accounted for using the equity method of accounting.
C. Credit risk of investments classified as held for trading.
D. Overall change in the fair value of a non-financial asset.

B. The fair value of an investment accounted for using the equity method of accounting is specifically excluded as being eligible to be hedged for accounting purposes under U.S. GAAP.

16

T/F: The accounting treatment applied to a derivative instrument depends on the purpose of the derivative instrument.

True

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