Derivatives and Hedge Accounting (F6M4)

Question 1

Derivative instrument

Answer 1

Financial instrument that derives its value from the value of other instruments and has the following characteristics:

1. one or more underlyings and one or more notional amounts
2. requires no initial net investment (FFS) or a one smaller than other similar contracts (options)
3. term requires a net settlement

Question 2

Underlying

Answer 2

specified price, rate or other variable.

what you are gambling on that will change value

Question 3

Notional amount

Answer 3

unit of measure used to calculate G/L.

ex: currency units, pounds, bushels etc

Question 4

Option contract

Answer 4

• Option buy must pay a premium - “max loss”
• call: gives holder right to buy at a specified price. so gain recognized if price goes up
• put: gives holder right to sell at a specified price. so gain recognized if price goes down
• NOT obligated to perform

Question 5

Futures contract

Answer 5

• agreement between two parties to exchange an asset at a specified price on a specified future date
• publicly traded
• OBLIGATED to perform
• buyer (long position) will recognize gain if price goes up.
• seller (short position) will recognize gain if price goes down

Question 6

Forward contract

Answer 6

-same as futures contract except it is privately traded

Question 7

Swap contract

Answer 7

• private agreement between two parties.
• hope what you receive goes up in value

-ex: interest rate swap - company A agreed to make payments of 8% and company B agreed to make payments of LIBOR + 1%

Question 8

Market risk

Answer 8

risk that entity will incur loss on derivative contract

Question 9

Credit risk

Answer 9

risk that the other party of the derivative contract will not perform accroding to the terms of the contract

Question 10

Derivatives on the balance sheet

Answer 10

• record as asset if “winner”/recognize receivable
• record as liability if “loser”/recognize payable

-measured at fair value

Question 11

Reporting gains and losses for speculative derivative

Answer 11

• no hedging designation

- gains/losses on income statement

Question 12

Fair value hedge

Answer 12

• hedge exposure to changes in FV of a recognized asset/liability
• hedge exposure to changes in FV or an unrecognized firm commitment

Question 13

Reporting gains and losses for fair value hedge

Answer 13

gains/losses on income statement

Question 14

Cash flow hedge

Answer 14

• hedge exposure to changes in expected future cash flows
  ex: if you plan to buy something in the future but do not have contract/obligation to do so
• long hedge: offset risk that cost of asset you’ll buy in the future goes up in value which would increase outflow
• short hedge: offset risk that asset you’ll sell in future goes down in value which will decrease inflow

Question 15

Reporting gains and losses for cash flow hedge

Answer 15

• Gains/losses on INEFFECTIVE portion - current income

- Gains/losses on EFFECTIVE portion - OCI (pufE*)

Question 16

FV hedge journal entries

Answer 16

-no JE on date of selling contract.

-JE on balance sheet date:
Dr. loss on purchase commitment
Cr. firm purchase commitment liability

Dr. FV hedge
Cr. gain on FV hedge

-JE on settlement date:
Dr. cash
Cr. FV hedge (reverse above)

Dr. Firm purchase commitment liability (reverse above)
Dr. Inventory (at FV price)
Cr. Cash (at commitment price)

Question 17

Foreign currency hedge risks

Answer 17

• if AR is denominated in foreign $. risk that Foreign $ goes down.
• if AP is denominated in foreign $. risk that Foreign $ goes up.

Question 18

Derivatives on statement of cash flows

Answer 18

• no hedging designation (speculation) = investment UNLESS held for trading then = operating
• hedge = same category as item being hedged

Question 19

Derivative disclosures

Answer 19

both GAAP and IFRS:

• description of entity’s objectives for each primary underlying risk exposure
• volume of derivative activity
• location (on BS i.e. asset/liability/line item) and FV (gross basis) of derivatives on BS.