Derivatives and Hedging

Question 1

What are the three characteristics of a derivative?

Answer 1

1. It has one or more underlyings and one or more of notional (hypothetical) amounts or payment provisions or both
2. It requires no initial net investment or one that is smaller than would be required for other types of similar contracts
3. Its items require or permit a net settlement or it can readily be settled net outside the contract or by delivery of an asset that gives substantially same results.

Question 2

What are considered a derivative?

Answer 2

A derivative is a financial instrument that derives from other financial instruments includes (OFFS):
- Options: a contract b/w 2 parties that gives one party the right (not an obligation) to buy (call) or sell (put) something to the other party at a specific price (strike/exercise price) during a specific period of time.
- Futures (public): an agreement b/w 2 parties to exchange a commodity, currency, or other assets at a specific price on a specific FUTURE date through clearinghouse.
- Forwards (private): similar to future contracts, but it’s done privately b/w two parties with assistance of an intermediary.
- Swaps: a series of forwards contracts.

Question 3

What are types of hedge instruments and accounting for change in fair value?

Answer 3

• Hedging is an investment intends to offset potential gains or losses that may incurred by companion investments. A perfect hedge is to have no possibility of future gain or loss because it’s used to offset others.
• Types of hedge instruments & their accounting:
  1. No hedge designation (speculate): include in earnings
  2. Fair value hedge: include in earnings
  3. Cash flow hedge: OCI
  4. Net investment hedge: OCI