Financial Instruments and Derivatives

Question 1

Define: Arbitrage

Answer 1

The ability to take advantage of price differentials in separate markets.

Question 2

Define: Derivative

Answer 2

Financial instruments requiring no significant initial net investment, that have one or more underlying and notional amounts on which the value of the derivative will be based, and that can be settled net.

Question 3

Define: Underlying

Answer 3

The factor used to determine the value of a derivative such as an interest or exchange rate, a future price, or an index.

Question 4

Define: Notional Amount

Answer 4

The quantity or number of units, such as shares of the principal balance of an instrument, to which the underlying will be applied to determine the fair value of a derivative.

Question 5

Define: Hedge

Answer 5

Use of a derivative to reduce or eliminate risk that an entity is subject to.

Question 6

Define: Speculation (non-hedge)

Answer 6

Taking on risk in hopes of profit.

Question 7

Define: Fair Value Hedge

Answer 7

Derivative acquired to hedge against changes in the fair value of a recognized asset or liability or firm purchase commitment. Changes in the value are reported in income from continuing operations of the income statement.

Question 8

Define: Cash Flow Hedge

Answer 8

Derivative acquired to hedge against changes in future cash flows in relation to a forecasted transaction. Changes in value of are reported as part of Other Comprehensive Income (OCI) until the transaction is complete.

Question 9

Define: Foreign Currency Hedge

Answer 9

Derivative acquired hedge against risk associated with changes in foreign currency exchange rates and that might be foreign currency fair value hedges or foreign currency cash flow hedges.