Financial Instruments & Derivatives Flashcards
What are financial instruments
- cash
- ownership interests in an entity (ex. stock)
- derivative contracts that create a right and obligation to transfer other financial instruments (ex. stock options)
what are notes and loans receivable or payable generally reported at?
amortized cost
what is amortized cost?
It is the cost of a security, plus or minus adjustments for any purchase discounts or premiums associated with the purchase of the security. A purchase discount arises when an investor pays less than the face value of a security in order to increase the effective interest rate, while a purchase premium is paid when the interest rate paid on a security is higher than the market rate.
Reasons an entity acquires derivatives
- investments
- arbitrage
- hedges
What is an arbitrage?
the ability to take advantage of price differentials in separate markets allowing the entity to enter into transactions that are potentially profitable without significant risk of loss.
What are the rules of arbitrage under a futures contract?
- if the market price is below the underling amount then the ENTITY will pay the difference btwn the underling & market price to the counter party in the buy contract. If the entity entered into another contract that had a higher underling price & the market price was higher than that contract price then it will EARN the difference btwn the underling and market.
NOTE: the whole concept is that the entity will either be paying and/or receiving the difference in the underling price in the contract and the market value. This helps the entity break even.
What is a hedge
the use of a derivative to reduce or eliminate a risk that the entity is subject to either as a result of an asset or liability recognized on its financial statements or a future transaction.
Why are derivatives used?
as hedges used to reduce or eliminate the risk of an adverse change in circumstance
What is the shortfall for having a derivative?
eliminates the opportunity to take advantage of a favorable change
How are derivatives reported on the F/S?
- maybe an asset or liability
- reported @ FV
- Unrealized gains/losses are generally reported in income
- *Note: cash flow hedges are temporarily reported as part of OCI on the B/S
- All other unrealized gains and losses are reported in income in the period in which the increase or decrease in value occurs.
What are the 3 characteristics that make a hedge a derivative?
NUNS
- No net investment - there must either be no initial net investment or an initial investment that is smaller than would normally be required for an instrument that would respond similarly in the market.
* *examples include: (interest rate swaps, futures contracts, and forward exchange contracts often require no initial net investment or an investment that is limited to fees paid to attorney and others to establish the derivative . - Underlying and Notional amount. the notional amount is basically the number of units (units, bushels, pounds) and the underlying is the factor that affects the derivatives value (specified price, interest rate, exchange rate).Ex in a forward exchange contract the notional amount wld be the # of FCU and the underlying would be the future exchange rate
- Net Settlement - the derivative can be settled in a net amount. remember the entity receives or pays the difference between the agreed upon exchange rate and the market rate
What are examples of derivatives?
- Option contract- (has the RIGHT but NOT OBLIGATION to purchase or sell in the future. Put options are the right to sell share; Call-options are the right to acquire shares in the future)
- Futures contract - (has RIGHT and OBLIGATION to deliver/purchase foreign currency or goods in the future at a price set today. Similar to a Forward contract normally traded on a national exchange)
- 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.
what risk do derivatives create?
- Off balance sheet risk due to the possible changes in amounts owed
- credit risk-risk that a loss occurs b/c another party fails to perform according to the terms of a contract
- required disclosures about each significant concentration (activity, region, or economic characteristic)
- must disclose the maximum amount of loss due to credit risk
- entity’s policy arrangements to mitigate the credit risk
- optional to disclose market risk which is the risk a loss may occur as a result of changes in the market value of financial instruments due to economic circumstances.
what is the “speculative use of derivatives”
when the entity enters into the contract.
what is intrinsic value for a company who wants to purchase stock for example
the option to purchase stock at a lower price than the current market price because if you turn around and sell the stock you would have a gain.
What is a fair value hedge derivative?
if the derivative is hedging against a recognized asset or liability on the balance sheet or a firm purchase commitment (meaning a legally binding contract) the changes in the value of the derivative are reported in Income from Continuing Operations.
what can fair value hedges be used against?
against the following:
- inventories
- the value of a fixed income investment
- the value of a fixed rate debt obligation
- a firm commitment
What are the characteristics and accounting procedures for a cash flow hedge?
If the derivative is hedging against a forecasted transaction that is expected to take place in the future, but which is not yet a legal commitment then changes in the value of the derivative are reported as direct adjustments to stockholder’s equity and included in other comprehensive income until the transaction is complete and the cash flows have ACTUALLY occurred.
what is the journal entry for a loss on a CASH FLOW HEDGE against an existing asset
Debit: Loss on market decline in inventory
Credit: Inventory (to reduce the amount of the inventory to record the loss)
then you do the following:
Debit: Receivable on derivative (for the same amount of the loss)
Credit: Gain on FV hedge (which appears on the B/S in Other Comprehensive Income)
Note there is no journal entry when the contracts are entered into b/c there is no cash or assets or anything involved other than a commitment.
When are speculation (non-hedge) used?
- acquire to take on risk in the hopes of profit
- gain or loss in income from continuing operations (I/S)
When are fair value hedges used?
- acquired to hedge against a RECOGNIZED asset or liability or a firm purchase commitment
- gain/loss in income from continuing operations (I/S)
- should be offset by loss or gain on hedged item
when are cash flow hedges used?
- acquired to hedge against a forecasted future transactions
- gain/loss in other comprehensive income (B/S)
- nothing included in net income until forecasted activity occurs
when does an entity use a foreign currency hedge against an investment in foreign operations
- acquired to hedge against currency risk from a major investment in a company w/a functional currency other than US dollars
- gain/loss in other comprehensive income (OCI) (B/S)
- offsets translation losses or gains from investment in foreign operations.
What are the requirements for non public entities to elect to use the alternative accounting approach for interest rate swaps
- the terms must be virtually identical such that they mirror the terms of the underlying obligation.
- the settlement date on which payments are exchanged for the swap are very close to the dates on which payments are made on the underlying obligation
- initial FV of the swap is zero indicating that the interest rates are comparable on the date it is entered into & that the parties have different views on anticipated future changes in the index rate
- the notional amount of the swap (the amount on which the swapped interest rates are calculated) must be equal to or lower than the principal balance of the hedged instruments
- all interest payments must be designated as hedged in proportion to the ratio of the notional amount of the hedge and the principal balance of the underlying obligation.
