Derivative Contracts Flashcards
Define a Derivative:
Financial instrument with value derived from some other item (share of stock, commodity, foreign currency, weather)
What are the elements of a derivative?
1) Has an underlying and notional amount or payment provision (if > then) and
2) Requires no or very small initial investment and
3) Requires settlement in cash in lieu of delivery of underlying
What is an underlying?
Specified price or rate (stock price, commodity price, foreign currency exchange rate)
What is the notional amount?
Specified unit or measure (shares of stock, pounds or bushels, number of foreign currency units)
Common derivatives include:
1) Options Contract- A right to buy or sell
2) Future contract- An obligation to buy or sell in the future at a price set now through a clearing house
3) Forward contract- An obligation to buy or sell in the future at a price set now, but directly between contracting parties
4) Swap contracts- exchange of cash flow stream usually associated with interest on debt; fixed interest payments for variable interest payments
How do you recognize and measure derivatives?
Recognize as an asset (contractual right) or liabilities (contractual obligation) at fair value.
Changes in fair value in a gain or loss recognized in earnings immediately unless it meets criteria for hedging.
What is the difference between a call option and a put option
Call (right to buy)
Put (right to sale)
What are examples of a host contract?
- Debt instruments (may have call option)
- Debt instrument (conversion feature)
- Leases (call option or put option)
If there is an embedded derivative in a host contract, how do you account for this?
You need to bifurcate. Bifurcation means that the derivative needs to be separated from the host instrument.
Record the derivative at fair value. The host instrument can be accounted for amortized cost or however you were accounting for it.
When do you bifurcate?
When the host contract and not clearly and closely related.
