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FAR > Derivative & Hedging pg 158 > Flashcards

Derivative & Hedging pg 158 Flashcards

1
Q

Derivative Elements

A
  1. One or more underlyings (specified price, rate) & one or more notional amts (shares, lbs, bushels)
  2. Requires NO initial net investment
  3. Terms require/permit a net settlement
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2
Q

Recognition & Measurement of a Derivative

A

Recognized as either asset or liability and measured at FV

Changes in FV will result in gains/losses

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3
Q

Embedded Derivative

A
  • Exists when host contract contains term or component that behaves like a derivative
  • When contains both host contract and embedded derivative called HYBRID instrument
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4
Q

Embedded Derivative separated from Host Contract IF

A

-Embedded Derivative separated from Host Contract IF:
1 Economic characteristics & risks of embedded are not clearly/closely related to characteristics & risks of Host
2. Hybrid Instrument is not itself remeasured to FV w/ changes reported in current income as they occur
3. As separate instrument, embedded would meet requirement of derivative instruments

–if has two embedded that can acct for as separate derivative those embedded must be bundled together and counted as 1

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5
Q

Measurement/Allocation when Embedded Derivative is separated from Host Contract

A
  • CV of host before separation is allocated b/w embedded derivative and host as follows:
    1. Derivative initially recorded at FV
    2. Diff b/w CV of hybrid contract and FV of derivative is initial value of remaining host contract
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6
Q

How to acct for Derivative when NOT designated for Hedge (Hedge=offset risk) Accounting

A
  • Initial Recognition: Acquired derivative contract is measured @ the then Current Fair Value
  • Subsequent Measure: Adj CV to FV & recognizing related Gain/Loss in CURRENT income
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7
Q

Options

A

Intrinsic Value: Strike (exercise) Price-Market Price
Time Value: Option Price-Intrinsic Value
Call Option: In-the-money when Strike PriceStrike Price
Put Option: In-the-money when Strike Price>Spot Price
Out-of-the-money when Strike Price<Spot Price

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8
Q

Natural/Economic Hedge

Hedge Accounting

A
  • Natural Hedge:Underlying risk and derivative are marked-to-market value thought earnings and changes in value of hedged risk and derivative offset to extent they match and no impacted on net income
  • Hedge Accounting: Gain/Loss on derivative used to match Loss/Gain on hedged item
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9
Q

Items to be documented for Hedge Accounting

A
  1. Risk Mgmt Objective/Strategy
    >Nature of risk and how hedging instrument (derivative)
    expected to reduce risk exposure
  2. Hedging Relationship
    >Hedged risk, hedged item, hedging instrument
  3. How effectiveness be assessed and method to
    measure ineffectiveness
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10
Q

Elements of Hedging

A
  1. Hedged Item: Recognized asset/liability/commitment/planned transaction that is at risk of loss (possible loss on hedged item that is hedged
  2. Hedging Instrument: Contract or other arrangement entered into to mitigate or eliminate risk of loss associated w/ hedged item
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11
Q

Types of Hedge Accounting

A

Fair Value Risk: Risk of loss due to changes in FV
Cash Flow Risk: Risk of loss due to changes in cash flows

Look @ Chart on Pg 165 of book 2 for summary

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12
Q

Eligible Items for Hedge Accting

A
  1. Commodity Price Risk
  2. Interest Rate Risk
  3. Foreign Exchange Risk
  4. Credit Risk (EXCEPT available for sale securities)
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13
Q

Common Transactions to Which Hedge Accting is Applied

A
  1. Forcasted Transaction

2. Firm Commitment

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14
Q

Forcasted Transactions

A

Transaction expected to occur which there is no firm commitment.

  • Will be @ prevailing market price.
  • MUST be specifically identifiable, probable to occur, with external party, doesn’t involve future A/L that will be remeasured thru earnings
  • Recorded @ market value on day forcasted transaction occurs
  • CASH FLOWS RISK
  • For Pros & Cons look at pg 166
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15
Q

Firm Commitment Transactions

A

Agreement w/ unrelated party that is binding on both parties and usually legally enforceable

  • AKA purchase/sales commitment
  • Recorded @ commitment price on date specified in firm commitment
  • FAIR VALUE RISK
  • For Pros & Cons look at pg 167
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16
Q

Excluded from using as a hedge instrument

A
  1. Nonderivative Instrument (treasury note)
    >Except for hedging changes in FV of unrecognized firm commitment attributable to foreign currency exchange rates OR hedging foreign currency exposure of net investment in foreign operation
  2. Components of compound derivative instrument used for different risks
  3. Hybrid Financial Instrument IF:
    > It is irrevocably elected to be measured in its entirety @ FV under FV option OR has embedded derivative that cannot be reliably identified and measured
17
Q

Fair Value Hedge

A
  • Hedge of exposure to changes in FV of RECOGNIZED A/L or UNRECOGNIZED firm commitment. Converts fixed price to floating price
  • Assessment of hedge effectiveness required when FS prepared @ least every 3 months
  • If hedged item is interest rate risk ONLY a benchmark interest rate risk may be hedged ONLY TWO are
    1. Direct U.S. Treasury Obligations
    2. London Interbank Offer Rate
18
Q

Accounting for Fair Value Hedges

A

1.If firm commitment, new A/L will have to be recognized on BS when initial adj occurs
2.Amt of adj to hedge becomes part of CV amt of item and is accted for as such
3. GAINS/LOSSES:If hedge normally adj thru OCI (AFS investment) change in FV must be recognized in current income (net effect of G/L reported in current income
4. If firm commitment and FV hedge no longer meets criteria A/L created must be written off and G/L reported in current income–
==Hedged A/L should continue to be assessed for impairment

19
Q

Cash Flow Hedges

A
  • Hedge of an exposure to variability in cash flow associated w/ RECOGNIZED A/L or foretasted transaction. Converts floating price to fixed price
  • Cannot involve A) business combo B) Parent’s equity interest in subsidiary C) Entity’s own equity instruments
20
Q

Accouting for Cash Flow Hedges

A

-Recognize in Other Comprehensive Income amt change in PV of cash flows associated w hedged item (effective portion)
-Recognize in Current income G/L amt by which derivative is diff from change in PV (ineffective portion)
1. Adj hedged item to FV each BS date and recognize change in FV in comprehensive income
2. Adj hedging instrument to FV each BS date and recognize chagne in FV as follows
> Amt up to amt equal to gain/loss recognized on
hedged item is recognized in comprehensive income
> Amt greater than amt of G/L recognized on hedged
item is recognized in current income

21
Q

Foreign Currency Hedge

A

-Hedge of exposure to changes in Dollar Value of A/L & planned transactions that are to be settled in currency other than entity’s functional currency
1.Forcasted Foreign Currency denominated transactions: >Risk being hedged is risk exchange rate changes will have on cash flow of non-firm but planned transactions to be settled in foreign currency
2.Unrecognized Foreign Currency denominated firm commitments:
> Risk being hedged is risk exchange rate changes will have on FV or Cash flow of firm commitments for future sale/purchase
3.Foreign Currency Denominated recognized A/L:
>Risk being hedged is FV or cash flow measured in dollars of already booked A/L to be settled in foreign currency (FV or cash flow) OR forecasted functional currency equivalent cash flow associated w/ recognized A/L (cash flow) OR investment denominated in foreign currency
4. Investments in Available-for-sale securities:
>risk being hedged is risk exchange rate changes will have on FV of investments in AFS securities (debt or equity) denominated in foreign currency
5. Net Investments in foreign operations:
>Risk being hedged is risk that exchange rate changes will have on FV of FS converted from a foreign currency to function currency

22
Q

Stages of Assessment Effectiveness

A

1.Prospective Consideration: Forward-looking of entity’s expectations that planned hedging relationship will be highly effective over future periods
> Based on Regression Analysis or other statistical analysis OR Qualitative assessment of extent to which critical terms of hedging instrument and hedged item match
2. Retrospective Evaluation: Relationship b/w instrument and item must continue to be assessed for effectiveness and measured for ineffectiveness whenever FS reported (at least every 3 months)
>Can be accomplished using # of approaches
1. Dollar-Offset: assessment based on how well $ change in hedging instrument actually has offset $ change in hedging item (period by period or cumulative basis)
2. Regression Analysis or other statistical analysis
3. Qualitative Assessment

23
Q

Effectiveness Testing

A

Correlation b/w hedged item adn hedging instrument must be b/w 80% & 125%
&raquo_space;>Change in FV Derivative/Change in FV hedged
risk=80%-125%

24
Q

Measuring Ineffectiveness

A

-Must be reported on income statement
1. Time Value: Entity must specify whether or not all or part of time value of hedging instrument will be included i assessment, any element NOT included in effectiveness assessment MUST be included in earnings in period of change
2. Short Cut Method: FADING OUT. Applies ONLY to hedging relationships of interest rate risk that involves recognized interest bearing financial A/L (item)and interest rate swap (instrument)
>Assumes change in value of interest rate swap is PERFECT proxy for change in value of interest bearing financial instrument
> Can only be used if ALL aspects of hedging relationship match exactly
> If ALL criteria are met entity may assume NO ineffectiveness in hedging relationship and DOES NOT have to carry our effectiveness assessment

25
Q

Disclosures

A

On pg 184-186

FAR (42 decks)

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