Derivative Flashcards
What is a futures contract?
Fixed price at a fixed time
Deals with clear house like NYSE
Like commodities hedge for farmers
Forward contract
Deals with brokerage agency, directly with the contracting parties, not through commodity trading clearing house
Usually with foreign currency
Call vs put option example
Derivatives. MV. $35 MV $25
Call (right to buy). In the money. Out of money
Put (right to sell). Out of money. In the. Money
Assume the stocks with $30 MV, the then 60 days later, the stock is sold at $35 a share, I make $5 per share (in the money), but if sold at $25, I lost $5 (out of money), to avoid the loss, I will let the option to expire.
Right to sell: when I can sell the price at $30, and the MV is at $35 for purchase, I will not make money, but if only $25, I can make $5 profit.
Futures and forwards are classified as?
Obligations
Examples of Embedded derivatives
Debt securities
Equity instruments
Leases
Need to separate the derivatives from the host contracts, means there is an option to exercise the option, derivative at FV, and the host contract will be measure at amortized cost, the have to be separated.
Debt instrument derivative
Equity instrument
Lease
What are the derivatives and host contract examples
Debt: inflection, interest rate and creditworthiness, it’s conditional, if those conditions happened, I will charge you extra for the condition.
Equity instrument: share price of equity instrument
Lease: inflation and interest rate
If the condition has something clause unrelated to the instrument then have to separate, if closely related to the instruments, then no worry about separating the instrument with host contract.
Derivatives held for speculation. (Obtain for profit)
Adjustment doe JE
Adjust FV at balance date
Mark to market, g/l through current earnings
Record as: dr. B derivative instruct cr. gain on derivatives
Derivative JE
- At initial investment
- Subsequent measurement and recognition
- Dr. Derivative investment cr. cash
2. Adjust at current FV and record G/L in current income
What are hedging and what examples are they?
The entity utilize a derivative to offset the risk related to a transaction.
Including natural or economic hedges that uses hedge accounting
Hedge accounting is a privilege that the entity can record g/l in OCI to distort the normal operant results
What are the qualifications for using hedge accounting?
Document the hedged items and how effective the hedge is
Documentation must be understandable by independent third party
Documentation for: 1) nature and risk of the item being hedged
2) how is hedge used to reduce risk
Hedging elements
1) hedged items and 2) hedging instrument
Financial assets and liabilities that qualified for hedge accounting
Commodities
Interest rate risk
Foreign currency risk ( including FC risk from net investment in foreign operation)
Credit risk (excluding AFS securities)
FV hedge: convert a fixed price to floating price
cash flow hedge: convert floating to fixed price
Both can hedge for recognized assets and liabilities and FC
FV hedge (asset/liability, firm commitment, foreign currency) hedge risk is the FV change
Adj. the CV to FV and with G/L included in NI
Cash flow hedge: (cognized asset/ liability, forecasted transactions when there is no firm commitment, foreign currency)
Ineffective portion in NI, effective portion in OCI
If asking the g/L on a specific year on the contract, record as the net of futures contract and purchase contract G/L for that year.
If asking the entire contract G/L with the firm commitment, use the net of both for that year as well
Exclusion for hedging accounting items
Non-derivative instruments such as T-notes
Component of compound instrument used for different risks
Hybrid financial instruments such as has embedded derivative but can’t be recognized and measured; and irrevocable elect to be measured at its entirety FV under FV option.
What kind of hedge is firm commitment? What elements need to be documented?
Is CF hedge the same requirements?
FV hedge
Elements to doc: 1) hedging relation; 2) objective and strategy for hedge 3) ID hedge items and instruments 4) nature and risk being hedged 5) effectiveness (must be highly effective, need to be assessed every 3 months). 6) how the asset and liability been recognized
CF hedge only have the first 5 elements
What can’t be FV hedged?
NCI
Using equity method for investment in S
Not for HTM security because interest rate change doesn’t matter, no need to hedge
If for no financial asset or liability, have to hedge the risk of loss for the entire thing, not portion
