Derivatives

Question 0

Examples of derivatives

Answer 0

1- Option contracts
2- Futures contracts
3- Forward contracts
4- Swap contracts
5- Contracts with characteristics comparable with those in the above listed contracts should be accounted for as derivative contracts.

Question 1

What are derivatives?

Answer 1

They are financial instruments with the following characteristics.

1- It has one or more underlyings, and one or more notional amounts.

2- It requires no initial net investment or a very small initial investment.

3- Its terms require or permit a net settlement.

An “underlying” is a specified price, rate, or other variable — i.e. Stick price, commodity price, interest rate etc.

A “notional amount” is a specified unit of measure — i.e. Shares of stock, bushel of cotton etc.

The value or settlement amount — of a derivative is the amount determined by the multiplication (or other arithmetic calculation) of the notional amount and the underlying — i.e. Shares of stock times price per share

Question 2

Items not derivatives

Answer 2

1- Normal purchase and sales contracts except financial instruments.
2- Regular security trades
3- Traditional life, property, and casualty insurance contracts.
4- Investments in life insurance
5- Contracts indexed to a company’s own stock
6- Contracts issued in connection with stock-based compensation arrangements
7- Contracts to enter into a business combination at a future date

Question 3

Recognition and measurement of derivatives

Answer 3

All derivative instruments must be recognized as either an asset (contractual rights) or a liability (contractual obligations) and measured at fair value.

Fair value measurement may cause gains and losses which will be reported in current income with exceptions if the derivatives were designated as hedges and if yes for what purpose.

Question 4

What is hedging?

Answer 4

Hedging means that the entity utilizes a derivative financial instrument to offset the risk related to a transaction, item or event.

Question 5

What are hedge elements?

Answer 5

Hedging involves two basic elements; those are:

1- Hedged item – The recognized asset, liability, commitment, or planned transaction that is at risk of loss. It is possible loss on the hedged item that is hedged.

2- Hedging Instrument – The contract or other arrangement that is entered into to mitigate the risk of loss associated with the hedged item.

Question 6

Types of hedge accounting

Answer 6

Hedge accounting essentially falls into two broad categories of accounting.

1- Fair value risk – The risk of loss due to changes in fair value.

2- The risk of loss due to changes in cash flows.

Risks identified as foreign currency risks or net investment in foreign operations risk embody specific forms of fair value and/or cash flow risks, some with unique accounting treatment.

Question 7

What items are eligible for hedge accounting?

Answer 7

1- Commodity price risk
2- Interest rate risk
3- Foreign exchange risk
4- Credit risk (except not for investments in available-for-sale securities).

Question 8

What are two common transactions to which hedge accounting is applied?

Answer 8

1- Forecasted transactions

2- Firm commitments