Flashcards in Foreign Currency, Derivative Instruments and Hedgin Deck (48):
Foreign currency transactions
Currency exchanging hands is not US Dollars
Foreign Currency Disclosures - ASC 830
1. Aggregate transation gain(loss) that is included in the entity's NI
2. Significant rate changes subsequent to the date of the financial statements including effects on unsettled foreign currency transactions. As of the B/S date you have to remeasure the payables and receivables according to the exchange rate for any particular foreign currency.
Monetary Unit Assumption
All F/S have to be in terms of the U.S. Dollar.
Exchange rate "on the spot"
Exchange rate as of the B/S date
When the foreign currency transaction rate applies
When money exchanging hands is not in US Dollars.
When there's a sale and there's a title of transfer. Not when an order is placed.
Derive their value as a financial instrument from something outside the instrument itself.
3 characteristics must be present for a financial instrument or other contract to be considered a derivative
1. one or more Underlying
2. one or more Notional
3. Settlement amount
The financial instrument or other contract requires no initial net investment or an inital net invest that is smaller than would be required (it's cheap)
The terms of financial instrument or other contract do one of the following in regard to settlement:
1. Require or permit net settlement
2. Provide for the delivery of an asset
How to measure Derivatives
Derivatives for Speculation
Unrealized holding gains and losses are reported in income from continuing operations. plus other revs and gains or minus other exps and losses
Fair Value Hedge
Hedge of the exposure to changes in the fair value of a) recognized asset or liability, or b) an unrecognized firm commitment (PO or contract).
Unreal gains and losses - Income from Cont'd ops. Plus other revs gains, Minus other exps and losses
Cash Flow Hedge
A hedge of the exposure to variability in the cash flows of a) a recognized asset or liability, or b) a forecasted transaction (haven't ordered anything)
Unreal gains and losses (effective portion) - Other comprehensive Income
Foreign Currency Hedge
A hedge of foreign currency exposure of a) an uncrecognized firm commitment (PO), b) avail-for-sale security (both of these are treated as a Fair value hedge), c) a forecasted transaction, or d) a net investment in a foreign operation (both of these are treated as Cash Flow hedges)
How to treat a Derivative instrument that does not qualify under any of the three categories
The gains and losses must be reported and recognized in current earnings. Income from Continuing Ops
Any financial or physical variable that has either observable changes or objectively varifiable changes (commodity prices, interest rates, exchange rate..) the thing that changes that causes the risk
the "number of currency or other units" specified in the financial instrument or other contract. (bushels of wheat, shares of stock)
of financial instruments or other contracts is calculated using the underlying(s) and notional amount(s) in some combination
as simple as multiplying the fair value of a stock times a speicified number of shares
The process of seperating an embedded derivative from its host contract. This process is necessary so that hybrid instruments can be seperated into their component part, each being accounted for using the appropriate valuation techniques
Criteria to determine if Bifurcation must occur
All three must be met
1. The embedded derivative meets the definition of a derivative
2. The hybrid instrument is not regularly recorded at fair value, with changes reported in current earnings.
3. The economic characteristics and risks of the embedded derivative instrument are not "clearly and closely related" to the economic characteristics and risks of the host contract.
ex. Convertible debt (investor's point of view) investment in a bond and stock option
How to value Bifurcations
Holder of a hybrid instrument normally requiring bifurcation can make the election not to bifurcate the instrument, instead the entire instrument is valued at fair value.
Unrealized gains/losses are reported in earnings each year, Income from Cont'd operations.
When elected not to bifurcate a hybrid instrument, how is this disclosed on the F/S
1. As seperate line items for the fair value and non-fair value instruments on the balance sheet.
2. As an aggregate amount of all hybrid instruments with the amount of the hybrid instruments at fair value shown in parantheses.
Highly effective hedge
Hedge will offset any gains or losses on the of the hedging item by 80%-125% of that change.
Criteria for unrecognized firm commitment to qualify as a hedged item
1. binding on both parties
2. specific with respect to all significant terms
3. contains a nonperformance clause
Cash flow hedge
Effective Portion- reported in OCI
Ineffective Portion and/or excluded components are reported on a cumulative basis - Income from continuing operations.
Foreign Currency Hedge - Unrecognized Firm Commitment
PO or contract.
treated as a FV Hedge
Unreal gains and losses - Income from Cont'd operations
Foreign Currency Hedge - Avail for sale securities
Treated as a fair value hedge
Unreal gains/losses - Income from cont'd operations
Foreign Currency Hedge - Foreign currency denominated forecasted transactons
Treated as a CF Hedge
Unreal gains/losses - Effective Portion- OCI
Ineffective Portion - Income from Con't ops
Foreign Currency Hedge- Net investments in foreign operations
Treated as a CF Hedge
Unreal gains/losses - Effective Portion- OCI
Ineffective Portion - reported on a cumulative basis to reflect the lesser of the cumulative gain/loss on the derivative or the cumulative gain/loss from the change in expected cash flows from the hedged instrument.
Hedges held for Speculative purposes
unrealized gains/losses - Income from continuing operations
Disclosures for Financial Instruments both derivative and non derivative that are used as hedging instruments
Objectives and the stragies for achieving them
Context to understand the instrument
Risk management policies and
A list of hedged instruments.
Fair value and Concentration of Credit Risk Disclosures of Financial Instruments other than Derivatives
Disclosures of FVs of financial instruments are required if it is practicable to estimte fair value.
Disclosures of concentration of credit risk is required.
The risk that a loss will occur because parties to the instrument do not perform as expected.
the possible amount of loss from an instrument that is not reflected on the B/S.
the risk that future changes in market prices may make a financial instrument less valuable.
IFRS Hedging Instruments
Fair value hedge - unreal G/L profit and loss (income from cont'd operations.
Cash flow hedge - unreal G/L Other comp Income
Hedge of a net investment in operations - unreal G/L - Other comp Income
At the money
price of the underlying is equal to the strike or exercise price.
A feature on a financial instrument or other contract, which if it stood alone, would meet the definition of a derivative.
An agreement with an unrelated party, binding on both, usually legally enforceable, specifying all significant terms and including a disincentive for nonperformance sufficient to make a performance likely.
A transaction expected to occur for which there is no firm commitment, and thus, which gives the entity no present rights or obligaitons. Forecasted transactions can be hedged and special hedge accounting can be applied.
In the money
A call option is in the money if the price of the underlying is greater than the strike or exercise price of the underlying.
Forward exchange contract
An agreement to exchange at a specified future date currencies of different countries at a specified rate (forward rate)
With regard to call (put) options, it is the larger of zero or the spread between the stock (exercise) price and the exercise (stock) price.
Out of the money
Call option is out of the money if they strike or exercise price is greater than the price of the underlying.
A put option is out of the money if the price of the underlying is greater than the strike or exercise price.
provides the holder the right to sell the underlying at an exercise or strike price, anytime during the option term. A gain accrues to the holder as the market price of the underlying falls below the strike price.
Forward based contract or agreement generallhy between two counterparties to exchange streams of cash flows over a specified period in the future.
Hedge acounting is permitted for (types of hedges)
Unrecognized firm commitments
Foreign currency denominated hedge forecasted transactions
Net investments in foreign operations
General criteria for a hedging instrument
Sufficient documentation must be provided at the beginning of the process and the hedge must be "highly effective" throughout its life.
An agreement between two parties to buy and sell a specific quantity of a commodity, foreign currency, or financial instrument at an aggregated upon price, with delivery and/or settlement at a designated future date. Not formally regulated by an organized exchange, each party to the contract is subject to the default of the other party.