Financial Instruments & Derivatives

Question 1

Investments in derivatives

Answer 1

An entity may invest its excess working capital, or amounts set aside in sinking funds, in derivatives such as stock options to increase its return on investment.

Question 2

Arbitrage

Answer 2

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.

Question 3

Hedge

Answer 3

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.

Question 4

Derivatives may….

Answer 4

1) be assets or liabilities
2) always reported at their fair value
3) Unrealized gains and losses are generally recognized in income
4) Unrealized gains and losses on cash flow hedges are temporarily recognized another comprehensive income instead of income

Question 5

Derivatives have the following three characteristics: (NUNS)

Answer 5

1) No net investment
2) an Underlying and a Notional amount
3) net Settlement

Question 6

No Net Investment

Answer 6

To be considered a derivative, there must be no initial net investment or an initial net investment that is smaller than would normally be required for an instrument that would respond similarly in the market. Derivatives such as 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 attorneys and others to establish the derivative.

Question 7

an Underlying and a Notional amount

Answer 7

the notional amount is basically the number of units (units, bushels, pounds) and he underlying is the factor that affects the derivative’s value (specified price, interest rate, exchange rate).

Question 8

net Settlement

Answer 8

The derivative can be settled in a net amount.

Question 9

Option Contract (example of derivative)

Answer 9

has right but NOT obligation to purchase/ sell in the future. Put-option, right to sell shares, call-option, right to acquire shares in the future.

Question 10

Futures contract (example of derivative)

Answer 10

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.

Question 11

Forward contract (example of derivative)

Answer 11

has right AND obligation to buy and sell a commodity at a future date for an agreed-upon price.

Question 12

Interest rate or foreign currency sway (example of derivative)

Answer 12

a forward-based contract or agreement between two counterparts to exchange streams of cash flows over a specified period in the future.

Question 13

Financial Instruments (COD)

Answer 13

Cash
Ownership interest in an entity
Derivative contracts that create a right and obligation to transfer other financial instruments (e.g. stock options)

Question 14

Credit Risk

Answer 14

risk that a loss occurs because another party fails to perform according to the terms of a contract

Question 15

Market Risk

Answer 15

Risk a loss may occur as a result of changes in the market value of financial instruments due to economic circumstances

Question 16

Speculation (non-hedge)

Answer 16

• acquired to take on risk in the hopes of profit.

- gain or loss in income from continuing operations (I/S)

Question 17

Fair Value Hedge

Answer 17

• acquired to hedge against a recognized asset or liability or a firm purchase commitment.
• gain or loss in income from continuing operations (I/S).
• should be offset by loss or gain on hedged item

Question 18

Cash Flow Hedge

Answer 18

• acquired to hedge against a forecasted future transaction.
• gain or loss in other comprehensive income (OCI) - (B/S)
• nothing included in net income until forecasted activity occurs.

Question 19

Foreign Currency hedge against an investment in foreign operations….

Answer 19

• acquired to hedge against currency risk from major investment in a company with functional currency (currency in which books are maintained) other than the U.S. dollar.
• gain or loss in other comprehensive income (OCI) - (B/S).
• offsets translation losses or gains from investments in foreign operations

Question 20

Intrinsic Value of a stock option

Answer 20

is the market price less the strike price