FAR 5 - Financial Instruments & Derivatives

Question 1

Financial Instruments inlude “C-O-D”

Answer 1

Cash

Ownership interest in an equity (stocks)

Derivative contracts that create a right & obligation to transfer other financial instriment (stock options)

Question 2

What are the three reasons entities aquire derivities?

Answer 2

1. Investments
2. Arbitrage
3. Hedges

Question 3

What are the three characteristic of a Derivative?

NUNS

Answer 3

Derivative contracts that creat a right & obligation to transfer other financial instruments.

A derivative is a financial instrument that meet certain requirements:

1. No net investment
2. An Underlying & a Notional amount
3. Net Settlement

Question 4

Derivative Examples

4 Main types

Answer 4

Option Contract - (has right but not obligation to purch/sell in the future) Put-options, right to sell shares; Call-options, right to aquire shares

Futures Contract - (has right & obligation to deliver/purchase foreign currency or goods in the futere at a set price today)

Forward Contract - has right & obligation to buy or sell a commodity at a future date for an agreed-upon price

Interest Rate or Foreign Currency Swap - a forward based contract or agreement between two counter parties to exchange streams of cash flows over a specified period in the future

Question 5

Fair Value Hedge

vs.

Cash Flow Hedge

Answer 5

FV Hedge - hedging against a recognized asset or firm purchase commitment. Change in value is recognized in income from continuing operations (I/S)

Cash Flow Hedge - hedging against a forecased transaction. Change in value is recognized in OCI

Question 6

What is a hedge?

Answer 6

A hedge is the use of a derivative to reduce or eliminate a risk that the entity is subject to either from an asset or liability recognized on its financial statement or a future transaction.

Question 7

Intrinsic vs. Extrinsic Value of Option Contracts

Answer 7

Smythe Co. invested $200 in a call option for 100 shares of Gin Co. $.50 par common stock, when the market price was $10 per share. The option expired in three months and had an exercise price of $9 per share. What was the intrinsic value of the call option at the time of initial investment?

The intrinsic value of a stock option is the market price less the strike price. At the time of initial investment each option had an intrinsic value of $1 ($10 market price less $9 strike price). The intrinsic value is 100 shares x $1 = $100.

The extrinsic value of stock options is the new market price less the market price at the time of the intial investment/options were agreed on.