FAR SEC 15 Flashcards
What is a derivative (basic definition)?
A derivative is a bet on whether the value of something will go up or down. The purpose is either to speculate (incur risk) or to hedge (avoid risk). The value of a derivative changes as the value of the specified variable changes. For example, a corn farmer can guarantee the price of his annual corn production using a derivative. In this case, the derivative is a hedge against the changes in the price of corn (to avoid risk).
Define call option.
A call option is the right (but not an obligation) to purchase an asset at a fixed price (i.e., the exercise price or the strike price) on or before a future date (i.e., expiration date).
Define put option.
A put option is the right (but not an obligation) to sell an asset at a fixed price (i.e., the exercise price or the strike price) on or before a future date (i.e., expiration date).
Define exercise price (strike price).
The exercise or strike price is the agreed-upon price of exchange in an option contract.
Define expiration date.
The expiration date is the date when the option may no longer be exercised.
Define underlying.
An underlying is the price, rate, or other variable (e.g., security price, commodity price, foreign exchange rate, etc.) specified in a derivative instrument.
Define notional amount.
A notional amount is the number of units (e.g., number of securities, tons of commodity, etc.) specified in a derivative instrument.
Define embedded.
Embedded means that a derivative is contained within either (1) another derivative or (2) a financial instrument.
-For example, a mortgage has an embedded option. The mortgagor (the debtor) generally has the option to refinance the mortgage if interest rates decrease.
Define spot price/rate.
The spot price/rate is the rate for immediate settlement of currencies, commodities, securities, etc.
Define forward price/rate
The forward price/rate is the rate for settlement of currencies, commodities, securities, etc., at some definite date in the future.
What are the three characteristics of a derivative?
1) A derivative is a financial instrument that has at least one underlying and at least one notional amount or payment provision, or both.
2) No initial net investment, or one smaller than that necessary for contracts with similar responses to the market, is required.
3) A derivative’s terms require or permit net settlement or provide for the equivalent.
i) Net settlement means that the derivative can be readily settled with only a net delivery of assets. Thus, neither party must deliver (a) an asset associated with its underlying or (b) an asset that has a principal, stated amount, etc., equal to the notional amount.
For derivatives, what is net settlement?
Net settlement means that the derivative can be readily settled with only a net delivery of assets. Thus, neither party must deliver (a) an asset associated with its underlying or (b) an asset that has a principal, stated amount, etc., equal to the notional amount.
What is the benefit of a call option to the purchase?
A call option allows the purchaser to benefit from an increase in the price of the underlying asset. The gain is the excess of the market price over the exercise price. The purchaser pays a premium for the opportunity to benefit from this appreciation.
What is the benefit of a put option to the purchaser?
A put option allows the purchaser to benefit from a decrease in the price of the underlying asset. The gain is the excess of the exercise price over the market price. The purchaser pays a premium for the opportunity to benefit from the depreciation in the underlying.
What are the two components of the price of an option?
The price of an option (option fair value) consists of two components: the intrinsic value and the time value.
What is the option price formula?
Option price = Intrinsic value + Time value
What is a forward contract? (4 elements)
1) A forward contract is an agreement for the purchase and sale of a stated amount of a commodity, foreign currency, or financial instrument at a stated price. Delivery or settlement is at a stated future date.
2) Forward contracts are usually specifically negotiated agreements and are not traded on regulated exchanges. Accordingly, the parties are subject to default risk (i.e., that the other party will not perform).
3) A forward contract to buy or sell foreign currency is called a forward exchange contract.
4) The fair value of this contract, both on the initial recognition date and the balance sheet date, is measured based on the forward exchange rate on those dates.
What is a futures contract?
A futures contract is a forward-based agreement to make or receive delivery or make a cash settlement that involves a specified quantity of a commodity, foreign currency, or financial instrument during a specified time interval.
What is an interest rate swap? (2 elements)
1) An interest rate swap is an exchange of one party’s interest payments based on a fixed rate for another party’s interest payments based on a variable rate. Moreover, most interest rate swaps permit net settlement because they do not require delivery of interest-bearing assets with a principal equal to the contracted amount.
2) An interest rate swap is appropriate when one counterparty prefers the payment pattern of the other. For example, a firm with fixed-rate debt may have revenues that vary with interest rates. It may prefer variable-rate debt so that its debt service will correlate directly with its revenues.
When is it appropriate to use an interest rate swap?
An interest rate swap is appropriate when one counterparty prefers the payment pattern of the other. For example, a firm with fixed-rate debt may have revenues that vary with interest rates. It may prefer variable-rate debt so that its debt service will correlate directly with its revenues.
Which financial instruments ARE NOT derivatives?
Certain financial instruments, e.g., accounts receivable, notes receivable, bonds, preferred stock, and common stock, are not derivatives. However, any of these instruments may be an underlying asset (security) in a derivative.
What is the accounting treatment for derivatives? (5 elements)
1) Derivatives should be recognized as assets or liabilities depending on the terms of the contract.
2) Fair value is the only relevant measure for derivatives.
3) The accounting for changes in fair value of a derivative depends on
i) The reasons for holding it,
ii) Whether the entity has elected to designate it as part of a hedging relationship, and
iii) Whether it meets the qualifying criteria for the particular accounting.
4) Derivatives not designated as a hedging instrument are measured at fair value through net income (i.e., gains or losses on the remeasurement to fair value are recognized directly in earnings).
5) Derivatives designated as a hedging instrument are measured at fair value through net income or at fair value through OCI, depending on whether the hedge is
i) A fair value hedge,
ii) A cash flow hedge, or
iii) A foreign currency hedge.
The accounting for changes in fair value of a derivative depends on which three elements?
The accounting for changes in fair value of a derivative depends on
1) The reasons for holding it,
2) Whether the entity has elected to designate it as part of a hedging relationship, and
3) Whether it meets the qualifying criteria for the particular accounting.
Derivatives designated as a hedging instrument are measured at fair value through net income or at fair value through OCI, depending on whether the hedge is_________________ (3 elements).
Derivatives designated as a hedging instrument are measured at fair value through net income or at fair value through OCI, depending on whether the hedge is
1) A fair value hedge,
2) A cash flow hedge, or
3) A foreign currency hedge.
What are the characteristics of hedge accounting? (3 elements)
1) The purchase or sale of a derivative or other instrument is a hedge if it is expected to neutralize the risk of (1) a recognized asset or liability, (2) an unrecognized firm commitment, or (3) a forecasted (anticipated) transaction.
i) For example, a flour company buys and uses wheat in its product. It may wish to guard against increases in wheat costs when it has committed to sell at a price related to the current cost of wheat. If so, the company will purchase wheat futures contracts that will result in gains if the price of wheat increases (offsetting the actual increased costs).
2) To qualify for hedge accounting, the hedging relationship must be highly effective. It should result in offsetting changes in the fair value (or cash flows) attributable to the hedged risk during the term of the hedge.
i) When the hedge is determined to be highly effective, hedge accounting is applied to the entire change in the fair value of the hedging instrument.
3) A fully effective (perfect) hedge results in no net gain or loss. It occurs when the gain or loss on the hedging instrument exactly offsets the loss or gain on the hedged item.
Under what three conditions is a derivative or other instrument a hedge?
The purchase or sale of a derivative or other instrument is a hedge if it is expected to neutralize the risk of (1) a recognized asset or liability, (2) an unrecognized firm commitment, or (3) a forecasted (anticipated) transaction.
What condition is necessary for a derivative or other instrument to qualify for hedge accounting?
1) To qualify for hedge accounting, the hedging relationship must be highly effective. It should result in offsetting changes in the fair value (or cash flows) attributable to the hedged risk during the term of the hedge.
-When the hedge is determined to be highly effective, hedge accounting is applied to the entire change in the fair value of the hedging instrument.
What is a perfect hedge?
A fully effective (perfect) hedge results in no net gain or loss. It occurs when the gain or loss on the hedging instrument exactly offsets the loss or gain on the hedged item.
Are all hedges derivatives?
No, not all hedges are derivatives, e.g., diversifying a portfolio is a form of hedging that doesn’t involve derivatives. Simply taking a position that is negatively correlated other assets would be a non-derivative hedge.
What are the three attributes of fair value hedges?
1) A fair value hedge mitigates the exposure to changes in the fair value of a recognized asset or liability or of an unrecognized firm commitment that are attributable to a specified risk.
2) Examples of hedged items are
i) Fixed-rate investments and debt and
ii) Firm commitments to purchase or sell assets or incur liabilities.
3) Gains and losses in relation to a fair value hedge must be accounted for as follows:
i) Gains or losses from changes in the fair value of the hedging instrument (derivative) are recognized immediately in earnings.
ii) Gains or losses from changes in the fair value of the hedged item attributable to the hedged risk are recognized immediately in earnings.
-The gain or loss from the change in the fair value of the hedging instrument is reported in the same income statement line item as the earnings effect of the hedged item.
How are gains and losses in relation to a fair value hedge accounted for? (3 elements)
Gains and losses in relation to a fair value hedge must be accounted for as follows:
1) Gains or losses from changes in the fair value of the hedging instrument (derivative) are recognized immediately in earnings.
2) Gains or losses from changes in the fair value of the hedged item attributable to the hedged risk are recognized immediately in earnings.
3) The gain or loss from the change in the fair value of the hedging instrument is reported in the same income statement line item as the earnings effect of the hedged item.
What are two examples of hedged items?
Examples of hedged items are
1) Fixed-rate investments and debt and
2) Firm commitments to purchase or sell assets or incur liabilities.
What are the attributes of cash flow hedges? (3 elements)
1) A cash flow hedge mitigates the exposure to variability in the cash flows of a recognized asset or liability or of a forecasted transaction that is attributable to a specified risk.
i) A forecasted transaction is probable, i.e., expected to occur, although no firm commitment exists. It does not (a) provide current rights or (b) impose a current obligation because no transaction or event has occurred.
ii) An example is an anticipated purchase or sale of inventory or item of property, plant, and equipment (a forecasted transaction).
2) Gains or losses from changes in the fair value of the hedging instrument (derivative) are recognized in OCI.
3) The amounts recognized in OCI (the gains or losses on the hedging instrument) are reclassified to earnings only when the hedged item affects earnings.
i) After the reclassification of these gains or losses from accumulated OCI to earnings, they are reported in the income statement in the same line item as the earnings effect of the hedged item.
For cash flow hedges, what is a forecasted transaction?
A forecasted transaction is probable, i.e., expected to occur, although no firm commitment exists. It does not (a) provide current rights or (b) impose a current obligation because no transaction or event has occurred.
-An example is an anticipated purchase or sale of inventory or item of property, plant, and equipment (a forecasted transaction).
What are the three attributes of foreign currency hedges?
1) Certain foreign currency exposures also may qualify for hedge accounting.
2) A derivative may hedge the foreign currency exposure to variability in a foreign currency (exchange rate fluctuations) in different foreign currency transactions.
3) A derivative may hedge the foreign currency exposure of net investments in a foreign operation. The accounting for gains and losses on the hedging instrument in a net investment hedge is accounted for similar to a cash flow hedge.
i) Gains and losses on the change in the fair value of the hedging instrument are recognized in the currency translation adjustment section of OCI.
ii) Those amounts are reclassified from accumulated OCI to earnings only when the hedged item affects earnings.
What are the attributes of embedded derivatives? (2 elements)
1) A common example is the conversion feature of convertible debt. It is a call option on the issuer’s stock. Embedded derivatives must be accounted for separately from the host if
i) The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics of the host;
ii) The hybrid instrument is not remeasured at fair value under otherwise applicable GAAP, with changes in fair value reported in earnings; and
iii) A freestanding instrument with the same terms as the embedded derivative is subject to the guidance on derivative instruments and hedging.
2) If an embedded derivative is accounted for separately, the host contract is accounted for based on the accounting standards that apply to instruments of its type. The separated derivative should be accounted for under the guidance on derivative instruments and hedging.
i) If the embedded derivative to be separated is not reliably identifiable and measurable, the entire contract must be measured at fair value, with gains and losses recognized in earnings.
ii) It may not be designated as a hedging instrument because nonderivatives usually do not qualify as hedging instruments.
Which three conditions are individually sufficient for embedded derivatives to be accounted for separately from their hosts?
Embedded derivatives must be accounted for separately from the host if
1) The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics of the host;
2) The hybrid instrument is not remeasured at fair value under otherwise applicable GAAP, with changes in fair value reported in earnings; and
3) A freestanding instrument with the same terms as the embedded derivative is subject to the guidance on derivative instruments and hedging.
If the embedded derivative is accounted for separately, which three conditions apply?
1) If an embedded derivative is accounted for separately, the host contract is accounted for based on the accounting standards that apply to instruments of its type. The separated derivative should be accounted for under the guidance on derivative instruments and hedging.
2) If the embedded derivative to be separated is not reliably identifiable and measurable, the entire contract must be measured at fair value, with gains and losses recognized in earnings.
3) It may not be designated as a hedging instrument because nonderivatives usually do not qualify as hedging instruments.
To which things to the guidance for disclosures about derivatives instruments and hedging activities apply?
The guidance for disclosures about derivative instruments and hedging activities applies to all entities and all derivatives and hedged items.
What are the specific disclosures required for derivatives and hedging? (4 elements)
The following are some of the disclosures for every reporting period for which a statement of financial position is issued:
1) Objectives of holding derivative instruments; their context, including each instrument’s primary risk exposure; and the entity’s related strategies.
i) A distinction must be made between instruments (whether or not hedges) used for (1) risk management and (2) other purposes. The entity must disclose which hedging instruments are hedges of fair value, cash flows, or the net investment in a foreign operation. If derivatives are not hedges, their purpose must be described.
2) Information about the volume of derivatives.
3) Location and gross fair values of reported derivatives.
i) These amounts are separately reported as assets and liabilities and classified as hedges and nonhedges. Within these classes, amounts are separately reported by type of derivative.
4) Location and amounts of gains and losses on derivatives and hedged items.
i) This information includes separate disclosures for (1) fair value hedges (hedging instruments and hedged items), (2) gains and losses on cash flow hedges and hedges of net investments that are currently recognized in OCI or reclassified from accumulated OCI, and (3) derivatives that are not used as hedges.
ii) The information is separately reported by type of derivative, with identification of line items.
What is shown on the resources & capital structure diagram?
What is shown on the transaction effects for liquidity ratios table?
