Financial Instruments Flashcards
Types of Hedges carried out using Derivatives
- FV Hedge
- Cash flow hedge
- Foreign currency hedge
Financial Instrument Assets
- Cash & cash equivalents
- Accounts Receivable
- Investments in debt & equity
- Interest in partnerships
- Option contracts with favorable terms
- Future’s & forward contracts with favorable terms
- Swap contacts with favorable terms
Financial Instrument Liabilities
- Accounts payable
- Notes & Bonds payable
- Option contract with unfavorable terms
- Future’s & forward contracts with unfavorable terms
- Swap contracts with unfavorable terms
When derivatives are use for speculative purposes
Intent is not to hedge an existing position but rather to make a profit
Financial Instrument Disclosure
- Significant concentrations and the maximum amount is risk and measured at gross FV
- FV disclosure can be in body of financial statements or in the notes
- If FV disclosure is not practicable describe why and include info relevant to estimating FV
Characteristics of a Derivative
- Has an underlying and a notional amount or a payment provision
- Requires no or very small investment
- Permits or requires settlement in cash, instead of delivery of the underlying
Underlying - Specified price or rate
- Stock price
- Commodity price
- Foreign currency exchange rate
Notional Amount - Specified unit of measure
- Shares of stock
- Pounds or bushels of a commodity
- Number of foreign currency units
Examples of derivatives
- Option contract: a right to buy or sell
- Futures contract: obligation to buy or sell in the future at a price set now through a clearhouse or exchange
- Forward contract: obligation to buy or sell in the future at a price set now directly between contracting parties
- Swap contact: exchange in cashflow stream usually associated with interest or debt; fixed interest payments for variable rate payments
Recognition & Measurement of Derivatives
- Either recognized as asset(contractual right) or liability (contractual obligation)
- Measured at FV
- change in FV results in gain or loss in earnings unless meets specific criteria or hedging
Embedded Derivatives
- Can be embedded in a “host” contract like debt instruments, equity instruments and leases
- If embedded derivative meets definition of a derivative then may need to bifurcate
Perfect Hedge
No risk of future gain or loss
Intrinsic Value of Call Option
Difference between the exercise(strike) price and the market price.
Hedges of foreign currency risks can be the hedge of
Can be either the risk to fair value in the foreign currency or the risk to cash flows in the foreign currency
Derivative instrument purposes
- Hedging purposes
- Speculative purposes
Derivative instruments can be used only to hedge FV or or cash flow
Both
Which one of the following is an item for which risk associated with the item cannot be hedged for accounting purposes?
The fair value of an investment accounted for using the equity method of accounting is specifically excluded as being eligible to be hedged for accounting purposes under U.S. GAAP
FV Hedges
Compare change in FV of hedged items and change in value of contract
FV ineffectiveness
Difference in the change in value of hedged item and contract
Firm Commitment
Occurs when an entity has a contractual obligation or contractual right, but no transaction has been recorded
In a cash flow hedge, the item being hedged is measured using
Measured using the present value of expected cash inflows or cash outflows
Cash Flow hedge
Hedge of an exposure to variability (changes) in the cash flow associated with a (recognized) asset, liability, or a forecasted transaction due to a particular risk. A cash flow hedge converts a floating price to a fixed price.
Forecasted transaction
A forecasted transaction is a planned or expected transaction which has not yet been recognized, but which is subject to the risk of changes in related cash flow. As such, the cash flow (inflow or outflow) associated with forecasted transactions can be hedged.
Foreign Currency Hedges
- Forecasted transaction denominated in a foreign currency: cash flow hedge
- Firm Commitment denominated in a foreign currency: Fair value
- ## Investment if AFS: FV hedge
When derivatives are used for cash flow or FV where are they recorded
- Cash flow: Accumulated Comprehensive Income
- FV: Income Statement
Gain or loss in earnings or AOCI
Must be disclosed
Notional Amount and IFRS
IFRS doesn’t recognize the notion
The process of bifurcation
Bifurcation is the process of separating an embedded derivative from its host contract
