Financial Instruments & Derivetives Flashcards
What are the financial instruments?
COD
- Cash
- Ownership interests in an entity (e.g. stock)
- Derivative contracts that create a right and obligation to transfer other financial instruments (e.g. stock options)
Why does a company obtain derivatives?
- Investment
- Arbitrage - take advantage of price differences / avoid risks (e.g. bond, stocks, commodity, futures contract)
- Hedge - reduce or eliminate risks
What are three types of derivatives?
- Cash flow hedges - B/S OCI
- Fair value hedges - trans. against assets that you own - gain/loss => I/S
- All other - gain/loss => I/S
What are derivatives characteristics?
- No net investment -you don’t really own anything / no initial investments
- An underlying and a notional amount - notional amount = units (e.g. lbs), underlying = factor that affects the price (e.g. exchange rate)
- Net settlement - settled in some net amount
What are examples of derivatives?
- Option contract - right (not an obligation), Put option ,(think value goes down), right to sell shares, call-option, right to acquire shares in the future)
- Futures contract - foreign currency/goods in future at a price set today (trade quickly)
- Forward contract - private agreements, one settlement date
- Interest rate or foreign currency swap
Fair value hedge vs Cash flow hedge
- Fair value hedge - hedging against recognizable asset - gain/loss => I/S
- Cash flow hedge - forecasted transactions
Fair value hedge Example: Buy oil 10/1 70 cents per gallon for 100M gallons, SP 80 cents, futures contract with settlement date 1/2, price drops 4 cents per gallon at YE
What are JE for 1. Purchase, 2) YE adjustment
- Purchase
DR: Inventory $70M
CR: Cash $70M - YE adjustment
DR: Loss on market decline in inventory $4M
CR: Inventory $4M
DR: Receivable on derivative $4M
CR: Gain on fair value hedge $4M
Forward exchange contracts - how is it recognized in I/S?
Forward exchange contract is a derivative acquired for speculation. It is reported at fair value on the B/S with and gain/loss in income.
Forward exchange contracts - question:
Bought 100K LCU’s in 90 days on 12/12/11. 12/12/11 exchange rate: spot rate 0.88, forward rate 0.90 (for 3/12/12)
12/31/11 exchange rate: spot rate 0.98, forward rate 0.93 (for 3/12/12)
At YE, what amount of foreign currency transaction gain should be in I/S?
On 12/12/11, no value since the purchase will be made on 3/12/12 (100k qty for 0.90).
At YE, the forward rate at 3/12/12 increased to 0.93 per LCU (so $90k is now worth $93k).
So, 3K is recognize as a gain in I/S.
What is characteristic of a perfect hedge?
No possibility of future gain or loss (eliminate the risk entirely).
Gains and losses of a hedging will be recognized in current earnings in each reporting period - cash flow hedge or/and fair value edge?
Fair value hedge, not cash flow hedge
Gain loss on cash flow hedge is reported in OCI.
How do you calculate the intrinsic value of a stock option?
Market price - strike price
$10/share in market - $9/share option price = $1
$1 x 100shares = $100 is intrinsic value.
Derivative - fair value hedge (e.g. future contract) - disclosure requirement
A company is required to document the relationship between the hedge and the hedged risk, and explain how the entity intends to measure the effectiveness of the hedge.
Financial instruments dominated in a foreign currency - how to record them?
- *spot rate on the B/S date
* *any increase/decrease is recognized in income/loss as foreign currency transaction gain/loss in I/S
What are interest rate swap agreement and what risks are inherent?
Interest rate swap is designed to convert a variable rate loan payable into a fixed rate to avoid losses due to anticipated increases in interest rates or to convert a fixed rate loan payable into a variable rate to benefit from anticipated decreases in interest rates.
Inherent risks involved in it are 1) the risk of exchanging a lower interest rate for a higher interest rate and 2) the risk of nonperformance by the counterparty to the agreement
