Derivatives And Hedge Accounting

Question 1

Derivatives

Answer 1

Financial instrument with an underlying, a notional amount, and a net settlement (such as a stock option).

Question 2

Underlying

Answer 2

Specified price or rate such as a stock price.

Question 3

Notional amount

Answer 3

Specified unit of measure such as # of shares

Question 4

Settlement amount

Answer 4

Determined by the underlying being multiplied by the notional amount, such as 100 shares at $20 per share

Question 5

Common types of derivatives

Answer 5

Option contracts
Future contracts
Forward contracts
Swap contracts- these are usually swapping fixed interest rate for a variable rate

Question 6

Measurement

Answer 6

Derivatives are recognized as either an asset or a liability and they are measured at fair value.

Changes in fair value result in gains or losses that are recognized in earnings

Question 7

Hedges

Answer 7

An asset or liability that is subject to a possible loss

Question 8

Hedging instrument

Answer 8

A contract or some other arrangement that mitigates the possible loss of the hedging item.

So we use a hedging instrument to hedge against a hedging item.

Question 9

Highly effective hedge

Answer 9

Effectively offsets the changes in cash flows or fair value that is being hedged against

Question 10

Items you would use hedging for

Answer 10

Commodity price fluctuation risk
Foreign exchange fluctuation risk
Interest rate fluctuation risk
Credit risk

Question 11

Fair value risk

Answer 11

This is the risk of loss due to a change in the fair value of a hedged item. This converts fixed risk into a floating risk.

Question 12

Firm commitment

Answer 12

An agreement that is usually legally enforceable that has been entered into with a third party. This agreement specified all significant terms such as dates, prices, and quantities. A fair value hedge would be used to hedge against this risk, because at the date the agreement is made, prices are locked down by the contract, but by the actual date of the transaction, market prices could have gone up or down.

Question 13

Basic accounting formula for fair value hedge

Answer 13

Adjust hedging instrument to FV at balance sheet date

Adjust hedged item to FV at balance sheet date

Recognize in current income the gain/loss from revaluing each

If the hedge does not exactly offset the gain or loss on the hedged item, the difference is a gain or loss in current income

Question 14

Cash Flow risk

Answer 14

Risk of loss due to a change in cash flows from a hedged item.

This converts a floating risk into a fixed rate.

Question 15

An example of cash flow risk

Answer 15

A forecasted transaction is an example of this type of risk. This is a transaction that is expected to occur. A cash flow hedge would be used with this type of transaction.

Question 16

Basic cash flow hedge accounting

Answer 16

Determine change in present value of expected cash flow of hedged item.

Recognize the difference in the fair value of the derivative up to the amount of change in present value of expected cash flow in other comprehensive income. This is the effective portion.

The amount different than the change in present value of expected cash flow in current income, this is the ineffective portion

Question 17

Disclosures

Answer 17

Entities that hold derivatives must disclose a lot of info about their reasons for using derivatives and the purposes of using derivatives.

They must also disclose information that distinguishes between fair value derivatives and cash flow derivatives.

Both the net gain or loss recognized in earnings during the period and the amount of gain or loss deferred in other comprehensive income must be disclosed