derivitaves

Question 1

what is a derivative

Answer 1

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

Question 2

underlying and notional amount

Answer 2

specified unit of measure

if then

Question 3

4 types of derivatives

Answer 3

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

Question 4

measurement

Answer 4

fair value and as a asset or liability. recognize adjustments in earnings unless it’s a hedge.

Question 5

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

Answer 5

buy

sell

Question 6

what is a embedded derivative and do you need to separate them?

Answer 6

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.

Question 7

how do you allocate embedded derivative and host contract?

Answer 7

report derivative at fv and the rest goes to host contract.

Question 8

hedging instruments purpose is to

Answer 8

increase certainty, decrease volatility and not make a profit

Question 9

natural or economic hedge

Answer 9

use a derivative to offset the price of a commodity, interest rate, anticipated purchase, foreign exchange exposure etc. no special hedging. through earnings.

Question 10

items eligible for hedge accounting

Answer 10

commodity price risk
foreign exchange
credit
interest

Question 11

fair value risk

Answer 11

risk of loss due to change in fv of item

converts fixed risk to floating

Question 12

cashflow risk

Answer 12

risk of loss due to change in fv of hedged item

converts floating risk to fixed

Question 13

unrecognized firm committment

Answer 13

is a legally binding contract not yet recognized as a liability /asset under gap

Question 14

fair value hedge (market to market to earnings)

Answer 14

is the hedge of an exposure to changes of a fair value of an asset/ lia or firm commitment.

Question 15

fv hedge must be ___ effective at hedging fv at bs date

Answer 15

highly

Question 16

firm commitments are not _____ until you actually purchase the item

Answer 16

recorded

Question 17

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

Answer 17

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

Question 18

Cash Flow Hedge

Answer 18

the hedge of changes of cashflow associated with an asset liability or forecasted transaction

Question 19

forecasted transaction

Answer 19

a planned transaction with another party for which rights and obligations have not yet been established.

Question 20

cashflow hedge converts

Answer 20

variable cashflows into fixed cashflows

Question 21

hedging most important thing is documentation.

Answer 21

objective, relationship, risk being hedged, how effectiveness is going to be assessed, how ineffectiveness is going to be measured,

Question 22

hedges must be assessed…

Answer 22

quarterly and at bs date

Question 23

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

Answer 23

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

Question 24

cash flow hedge earnings go into
fair value hedge earnings go into
(Or aka effective portion)

Answer 24

OCI

NI

Question 25

foreign currency hedge

Answer 25

mitigate the changes in the value of assets/lia and forecasted transactions that are denominated in a foreign currency.