derivitaves Flashcards
what is a derivative
a derivative is a financial instrument with a underlying, notional or payment provision.
requires no or very small initial investment
permits or requires settlement in cash in lieu of delivery of the underlying
underlying and notional amount
specified unit of measure
if then
4 types of derivatives
options-stock options
futures -exchange in the future to price set now. done through a clearing house
forward contract- like a future but done through parties
swaps- swap fixed rate for variable rate. vice versa
measurement
fair value and as a asset or liability. recognize adjustments in earnings unless it’s a hedge.
call- right to____
put-right to _____
in the money is good- you want to exercise
out of the money is bad-dint want to exercise
buy
sell
what is a embedded derivative and do you need to separate them?
a derivative hidden in a host contract. if this is the case then you need to separate the two (bifurcate) if they are not clearly and closely related. if they are clearly and closely related you do not need to separate them.
how do you allocate embedded derivative and host contract?
report derivative at fv and the rest goes to host contract.
hedging instruments purpose is to
increase certainty, decrease volatility and not make a profit
natural or economic hedge
use a derivative to offset the price of a commodity, interest rate, anticipated purchase, foreign exchange exposure etc. no special hedging. through earnings.
items eligible for hedge accounting
commodity price risk
foreign exchange
credit
interest
fair value risk
risk of loss due to change in fv of item
converts fixed risk to floating
cashflow risk
risk of loss due to change in fv of hedged item
converts floating risk to fixed
unrecognized firm committment
is a legally binding contract not yet recognized as a liability /asset under gap
fair value hedge (market to market to earnings)
is the hedge of an exposure to changes of a fair value of an asset/ lia or firm commitment.
fv hedge must be ___ effective at hedging fv at bs date
highly
firm commitments are not _____ until you actually purchase the item
recorded
Fair Value Hedge Example
Assume the company enters into a firm commitment with a supplier of cotton on jan 1 to purchase 1m tons of cotton on march 31 for 42$/ton. in order to protect against fv changes the company enters into a futures contract on jan 1 to sell cotton on march 31 for 42$/ton. the futures contract was purchased at the money, therefor there was no cash outlay for the futures contract.
jan 1 feb 28 march 31
spot 40 38 37
futures 42 41 37
entry with broker with futures contract
feb
futures contract 1m
gain/loss (NI) (41-42*1000) 1m
march
futures contract 4m
gain/loss (37-41*1000) 4m
cash(42-37*1000) 5m
futures contract 5m
entries with firm commitment with supplier
feb
gain/loss (41-42) 1m
firm commitment 1m
march
gain/loss (37-41*1000) 4m
firm commitment 4m
Inventory 37m
Firm Commitment 5m
Cash 42m
Cash Flow Hedge
the hedge of changes of cashflow associated with an asset liability or forecasted transaction
forecasted transaction
a planned transaction with another party for which rights and obligations have not yet been established.
cashflow hedge converts
variable cashflows into fixed cashflows
hedging most important thing is documentation.
objective, relationship, risk being hedged, how effectiveness is going to be assessed, how ineffectiveness is going to be measured,
hedges must be assessed…
quarterly and at bs date
cash flow Hedge Example
Assume the company enters into a firm commitment with a supplier of cotton on jan 1 to purchase 1m tons of cotton on march 31 for 42$/ton. in order to protect against fv changes the company enters into a futures contract on jan 1 to buy cotton on march 31 for 42$/ton. the futures contract was purchased at the money, therefor there was no cash outlay for the futures contract.
jan 1 feb 28 march 31
spot 40 46 44
futures 42 45 44
Entries with Broker
feb
Futures contract 3m
Gain/loss-oci 3m
March
Gain/Loss-oci 1m
Futures Contract 1m
Cash 2m
Futures Contract 2m
Entries for forecasted transaction with supplier
March
inventory cotton 44m
Cash 44m
cash flow hedge earnings go into
fair value hedge earnings go into
(Or aka effective portion)
OCI
NI
