Financial Instruments & Derivatives

Question 1

What is a Financial Instrument?

Answer 1

1) Cash
2) Ownership interests in an entity (such as stock)
3) Derivative contracts that create a right and obligation to transfer other financial instruments (such as stock options)
“C-O-D”

Question 2

What are the three main reasons why entities acquire derivatives?

Answer 2

1) Investments
2) Arbitrage
3) Hedge

Question 3

Are derivatives assets or liabilities?

Answer 3

Trick question! They can be both.

Question 4

What value are derivatives reported at?

Answer 4

Derivatives are always reported at their FAIR VALUES! (cost upon acquisition, which is effectively Fair Value)

Question 5

Where are unrealized gains and losses on derivative cash flow hedges recognized?

Answer 5

In Other Comprehensive Income (the “D” in “D-E-N-T”; kind of like Available-for-Sale Securities)

Question 6

Where are unrealized gains and losses on fair value hedges recognized?

Answer 6

In Income, along with any offsetting losses or gains on the hedged item (kind of like Trading Securities)

Question 7

When are all unrealized gains and losses on hedges recognized?

Answer 7

In the period of the increase or decrease in value

Question 8

Derivatives are financial instruments that have what characteristics?

Answer 8

1) No net investment
2) An Underlying and Notional Amount
3) A Net Settlement
“N-U-N-S”

Question 9

Regarding derivatives, what is meant by an underlying amount?

Answer 9

The main factor affecting the derivative’s value, such as a specified price, interest rate, or exchange rate

Question 10

Regarding derivatives, what is meant by a notional amount?

Answer 10

The NUMBER of units such as bushels, pounds, or amount of foreign currency (foreign currency units, FCUs)

Question 11

What derivative contract has the right, but not the obligation to sell shares in the future?

Answer 11

A put-option contract

Question 12

What derivative contract has the right, but not the obligation to acquire shares in the future?

Answer 12

A call-option contract

Question 13

What derivative contract has both the right and obligation to deliver or purchase foreign currency or goods in the future at a price set today?

Answer 13

A futures contract

Question 14

What derivative contract has both the right and obligation to buy or sell a commodity at a future date for an agreed-upon price?

Answer 14

A forward contract

Question 15

What is an agreement between two parties to exchange streams of cash flows over a specified period in the future?

Answer 15

An interest rate (or foreign currency) swap

Question 16

If entering into an interest rate swap, what disclosures (relating to the off-balance sheet risk) need to be made?

Answer 16

1) Risk of exchanging a lower interest rate for a higher one

2) Risk that the other bank (party) might default on the agreement (counterparty/default/credit risk)

Question 17

What type of derivative hedges against a recognized asset, liability, or firm purchase agreement?

Answer 17

Fair value hedge

Question 18

What type of derivative hedges against a forecasted transaction expected to take place in the future, but which isn’t yet a legal commitment?

Answer 18

Cash flow hedge

Question 19

What is a Fair Value Hedge?

Answer 19

A derivative that offsets exposure to changes in the value of a recognized asset, liability, or firm purchase agreement

Question 20

What is a Cash Flow Hedge?

Answer 20

A derivative that hedges against a forecasted transaction expected to take place in the future, but which isn’t yet a legal commitment

Question 21

How is a Fair Value Hedge recorded?

Answer 21

Initially recorded on Balance Sheet at Fair Value

Gains/Losses recorded on Income Statement. Should be offset by loss or gain on hedged item.

Question 22

How is a Cash flow Hedge recorded?

Answer 22

Initially recorded on Balance Sheet at Fair Value

Gains/Losses going to OCI.

Example: A cereal company enters into a futures contract on grain purchases to offset the risk that grain will go up in price. No effect on net income until forecasted event/activity occurs.

Question 23

How would Speculation Hedges be recorded?

Answer 23

Initially recorded on Balance Sheet at Fair Value

Gains/Losses recorded on Income Statement. Should be offset by loss or gain on hedged item.

Question 24

What is meant by a “Perfect Hedge”?

Answer 24

No possibility of future gain or loss

Question 25

What features comprise compound or hybrid instruments such as convertible stock?

Answer 25

1) A host instrument (the bond)

2) An embedded derivative (conversion feature)

Question 26

If the host instrument of a hybrid instrument is not reported at fair value, how is the embedded derivative treated (valued)?

Answer 26

The embedded derivative would be separated from the host instrument (bifurcation) and accounted for separately?

Question 27

What is it called when separating a derivative from the host instrument and accounting for it separately?

Answer 27

Bifurcation

Question 28

How are hybrid instruments usually valued?

Answer 28

Usually at fair value since their embedded derivative is required to be valued at fair value

Question 29

What disclosures are required for derivative transactions?

Answer 29

1) Objectives and Strategies
2) Context to help investor understand the instrument
3) Risk Management Policies
4) Complete List of Hedged Instruments

Question 30

In order to recognize the transfer of financial instruments as a sale, what conditions must be satisfied?

Answer 30

1) Asset must be beyond reach of the transferor and its creditors (“Out of my hands”)
2) The transferor cannot place any restrictions on what the transferee can do with the asset (“No control over its future use”)
3) There is no repurchase or redemption agreement that might allow the transferor to force a return of the asset (“No buyback clauses”)