Financial Instruments

Question 1

Define Derivative

Answer 1

Financial Instruments whose value or settlement amount is derived from the value of another unit of measure

Question 2

3 Characteristics a Derivative MUST have

Answer 2

1. Atleast one underlying and at least one notional amounts or payment provisions 2. Requries NO initial investment 3. Its terms require or permit a net settlement

Question 3

How do you apply the Fair Value option?

Answer 3

unrealized gains and losses are reported in earnings. The FV option is irrevocable and is applied to individual financial instruments. Ex: Unrealized G/Ls on AFS securities may be recognized in earnings rather than OCI.

Question 4

Items not eligible for Fair Value Option

Answer 4

“VIPs Love Extra Drinks”

1. Investments in Sub 2. VIEs 3. pension benefit assets or liabilities 4. financial assets or liabs recognzied under leases 5. deposit liabilities of financial institutions 6. financial instruments classified as equity

Question 5

IFRS: When can you apply the Fair Value Option?

Answer 5

IFRS: The FV option may only be elected for financial assets if doing so eliminates or significantly reduces a measurement or recognition inconsistency.

Question 6

Describe the Disclosures for Risks under US GAAP

Answer 6

U.S. GAAP 1. An entity must disclose concentration of credit risk (which occurs when an entity has contracts of material value with one or more parties in the same industry or region or having similar economic characteristics). 2. Entities are encouraged, NOT REQUIRED, to disclose market risk.

Question 7

Describe the Disclosures for Risks under IFRS

Answer 7

1. credit risk 2. market risk 3. liquidity risk **Note: Market risk disclosure is NOT optional under IFRS, as it is under US GAAP

Question 8

Define underlying

Answer 8

a specified price, rate, or other variable

Question 9

Define notional amount

Answer 9

specified unit of measure

Question 10

Settlement Amount

Answer 10

Settlement Amount = Underlying x Notional Amount

Question 11

Define Payment Provision

Answer 11

a settlement to be made if the underlying behaves in a certain way

Question 12

Define Hedging

Answer 12

The use of a derivative to offset anticipated losses or to reduce earnings volatility. Reduces risk of holding/trading certain assets.

Question 13

Define Option Contract

Answer 13

a contract that gives one party the right, but NOT the obligation, to buy or sell something to the other party at a specified price (aka strike or exercise price). The buyer, or holder, must pay a premium to the option seller, or writer, to enter into the option contract.

Question 14

Define Call Option

Answer 14

Gives the holder the right to buy from the option writer at a specified price during a specified period of time. The holder hope the market price increases, so when the holder actually buys, they can get it cheaper at the contract price or settlement amount.

Question 15

Define Put Option

Answer 15

Gives the holder the right to sell to the option writer at a specified price during a specified period of time. The holder hopes the price decreases so that the contract price (or settlement amount) is more than the market price, so the holder can make a profit.

Question 16

Defines Futures Contract

Answer 16

1. An agreement between two parties to exchange a commodity or currency at a specified price on a specified future date. 2. It is PUBLICLY TRADED, unlike Forwards and Swaps.3. One party takes a long position and agrees to buy an item. 4. The other party takes a short position and agrees to sell the item. 5. made through a clearinghouse 6. have standardized notional amounts & settlement rates 7. Both parties are obligated to perform

Question 17

Futures Contract: When a party takes the long position, when do they make profit?

Answer 17

They make profit when the market Price INCREASES. Note: Long position means one party agrees to buy something.

Question 18

Futures Contract: When a party takes the short position, when do they make profit?

Answer 18

They make profit when the market Price DECREASES. Note: when a party takes the short position, they agree to sell an item. Short, Sell.

Question 19

Forward Contract

Answer 19

Similar to Futures Contract, except: 1. Private. 2. assistance of immediary, instead of clearinghouse 3. No standardized amounts (the terms are established by parties of the contract)

Question 20

Define Swap Contract

Answer 20

1. private 2. assisted by intermediary 3. to exchange future cash payments Note: a swap agreement is the same as a series of forward contracts.

Question 21

Types of Swaps

Answer 21

1. interest rate swaps 2. equity swaps 3. commodity swaps

Question 22

How are derivaties presented on the F/S?

Answer 22

presented on the balance sheet as assets or liabilities and measured at FAIR VALUE

Question 23

How do you report G/Ls for Derivatives with No Hedging Designation?

Answer 23

Include in current earnings

Question 24

How do you report G/Ls for Fair Value Hedges?

Answer 24

Include in current earnings as an offset to the G/L from the change in fair value of the hedged item

Question 25

How do you report G/Ls for the Effective Potion of Cash Flow Hedges?

Answer 25

Included in OCI until the hedged transaction impacts earnings

Question 26

How do you report G/Ls for the Ineffective Portion of Cash Flow Hedges?

Answer 26

Included in current earnings

Question 27

How do you report G/Ls for Foreign Currency Fair Value Hedges?

Answer 27

Included in current earnings as an offset to the G/Ls from the change in fair value of the hedged item

Question 28

How do you report G/Ls for Foreign Currency Cash Flow Hedge?

Answer 28

Effective portion - include in OCI until impacts earnings. Ineffective portion - included in current earnings.

Question 29

How do you report G/Ls for a Foreign Currency Net Investment Hedge?

Answer 29

Included in OCI as a cumulative translation adjustment.