Lecture 5: Financial Instruments & Derivatives

Question 1

Financial Instruments include (COD)

Answer 1

Cash
Ownership interests in an entity (Stock)
Derivative contracts that create a right and obligation to transfer other financial instruments (Stock Options)

Question 2

Why companies acquire Derivatives (ASC 815)

Answer 2

They acquire them as investments, arbitrage or as hedges

Question 3

Investments

Answer 3

a company may invest it’s extra working capital or amount in a sinking fund in derivatives such as stock options to increase their return on investment.

• Based on a lower investment amount, the return is greater
• if the value of the stock decreases, there is a comparably disproportionate decrease in the value of the derivative, making it a high risk investment

Question 4

Arbitrage

Answer 4

is the ability to take advantage of price differentials in separate markets allowing the entity to enter into transactions that are potentially profitable without significant risk of loss. Buy and sell the investment simultaneously to avoid any risk.

Question 5

Hedge

Answer 5

This helps an investor from a complete loss. This is the use of a derivative to reduce or eliminate a risk that the entity is subject to either as a result of an asset or liability recognized on its FS or a future transactions. If you purchase an asset at $1 and are unsure of future Market Conditions, you can agree upon a certain sell price of $2 and this will be your right but not the obligation at a certain date that you can sell for $2 no matter what the Market price is. You can receive a gain on the sale but there will be no loss.

Question 6

Characteristics of Derivatives (NUNS)

Answer 6

• No Net Investment: no initial net investment or initial net investment that is smaller than would normally be required for an instrument that would respond in the market.
• Underlying and Notional Amount: Underlying is the factor that affects the derivatives value (specified price, interest rate, exchange rate) and the Notional amount is the number of units (bushels, pounds)
• Net Settlement: derivative can be settled in a net amount

Question 7

Derivatives can be ____ or _____.

Answer 7

Assets or liabilities

Question 8

Derivatives are reported at____

Answer 8

Fair values

Question 9

For derivatives, unrealized G/L are recognized ______

Answer 9

on the IS

Question 10

For Cash Flow Hedges, unrealized G/L are recognized in _____

Answer 10

Other comprehensive income on the BS temporarily

Question 11

Unrealized G/L for Fair Value Hedges are recognized on the______

Answer 11

IS, along with offsetting gains or losses on the hedged item.

Question 12

Option Contract

Answer 12

has the right but not the obligation to purch/sell in the future.

• Put Option: right to sell
• Call Option: right to buy

Question 13

Futures Contract

Answer 13

has the right AND obligation to deliver/purchase foreign currency or goods in the future at a price set today. (Similar to Forward Contract and traded on the national exchange)

Question 14

Forward Contract

Answer 14

has the right AND obligation to buy/sell a commoditiy at a future date for an agreed upon price.

Question 15

Interest Rate/Foreign Currency Swap

Answer 15

A forward based contract or agreement between two couterparties to exhange streams of cash flows over a specified period in the future.

Question 16

Off Balance Sheet Risk

Answer 16

Derivatives can create Off Balance Sheet risk due to the possible changes in amounts owed, credit and market risk must be disclosed

Question 17

An example of a private derivative would be______

Answer 17

an interest rate swap: a bank has made a large number of loans with a variable rate might contract with a bank who has made a large number of Fixed rate loans. The first bank is concerned about a drop in rates that would reduce their interest income and the latter bank is concerned about increasing rates and losing out on profits from the interest income increase.

Question 18

FV Hedge

Answer 18

If derivative is hedging against a RECOGNIZED Asset/liability on the BS, or a FIRM purchase commitment, then changed in the value of derivative go to INCOME from continuing operations. (fixed income investment, fixed rate debt obligation, and firm commitment)

Question 19

CF Hedge

Answer 19

If the derivative is hedging against a FORECASTED transaction that is expected to take place in future, but which a legal commitment does not exist. All changed in FV are reported as direct adjustments to SHE in OCI until the transaction is complete and the cash flows have actually occurred. Dent

Question 20

Goal of Hedge or “perfect hedge”

Answer 20

no net income effect, eliminates all risk

Question 21

Speculation facts

Answer 21

a Non-Hedge, acquired to take on risk in hopes of a profit, unrealized g/l go to Income from continuing operations.

Question 22

FV Hedge facts

Answer 22

• acquired to hedge against a recognized A or L or a firm purchase agreement.
• G/L goes to Income, should be offset by loss or gain on hedged item

Question 23

CF Hedge Facts

Answer 23

• Acquired to hedge against forecasted future transaction
• G/L goes to OCI on BS
• Nothing included in net income until forecasted activity occurs.

Question 24

Foreign Currency Hedge against an investment in foreign operations

Answer 24

Acquired to hedge against a currency risk from a major investment in a company with a functional currency (Currency in which books are maintained) other than the US Dollar

• G/L goes to OCI on BS
• Offsets translation losses or gains from investment in foreign operations.

Question 25

An investment in bonds has two inherent risks:

Answer 25

1. Credit Risk: because the issuer of bonds may or may not perform, which will affect the interest rate
2. Market Risk: because the bonds will bear interest at Fixed Rates or Market Rates which change, making the bonds less or more desirable and causing increases/decreases in their FV.

Question 26

Convertible Bonds

Answer 26

added feature that can be converted into CS. This is a hybrid instrument, the bond is the host and the conversion feature is the embedded derivative.

Question 27

If a host instrument is reported at FV, the derivative is also reported at ______

Answer 27

FV.

Question 28

If a host instrument is not reported at FV, the derivative will be_____

Answer 28

bifurcated from the host and accounted for separately.

Question 29

Under IFRS, there are 3 types of hedges:

Answer 29

1. Cash Flow Hedges: G/L got to OCI (Same as GAAP)
2. FV Hedges: G/L go to IS (Same as GAAP)
3. Hedges of net investments in foreign operations: G/L go to OCI ( “T” in DENT)

Question 30

Under IFRS, Compound Financial Interests are_______ that have both a _____ and ______ components (e.g. Convertible bonds)

Answer 30

non-derivative, liability and equity

*Under GAAP they are only split if certain requirements are met “NUNS”

Question 31

Under IFRS, when the host contract is a financial asset, it is reported as____

Answer 31

a single instrument and is accounted for under amortized cost method or FVTPL

Question 32

Under IFRS, when the host contract is NOT a financial asset, the embedded derivative is _______

Answer 32

separated or bifurcated from the host instrument and accounted for separately