Financial Instruments & Derivatives Flashcards
What is considered a financial instrument? (Think Smelly)
C.O.D
C - Cash
O- Ownership Interests in an entity (Stock)
D- Derivative contracts that create a right and obligation to transfer other financial instruments (stock options)
How should all derivatives be reported on the financial statements?
At fair market value
Why do entities acquire derivatives?
- Investments
- Arbitrage
- Hedge
What is 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 is a Hedge?
A hedge is 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.
e.g. think of a oil distributor and the price of gasoline. They buy it a x amount today but worried price of oil may go down (decreasing the value of their inventory), so they enter into a futures contract (hedge) with a company in case the price drops to protect the inventory.
What is a call option?
It’s the right to buy at a specified price when you think that the price may go up
What is a put option?
It’s the right to sell at a specified price when you think that a price may go down
What are the characteristics of a derivative?
NUNS
N - No Net Investment
UN - An underlying and a Notional Amount
S - Net Settlement
No Net Investment
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. Limited fees such as those paid to attorneys and others to establish the derivative are okay.
Examples of derivatives that meet this characteristic: interest rate swaps, futures contracts, forward exchange contracts
What is the underlying?
The underlying is the factor that affects the derivatives value (specified price, interest rate, exchange rate)
What is the notional amount?
The notional amount is the number of units (units, bushels, pounds)
What is the Net Settlement?
The derivative can be settles in a net amount.
E.g. in a forward exchange contract the entity does not actually buy or sell the FCUs but instead receives or pays the difference between the agreed upon exchange rate and the market rate.
In the case of an interest rate swap, the parties don’t pay each other the contractual interest, but the difference is paid from one party to the other.
Name some examples of derivatives?
Option Contract
Futures Contract
Forward Contract
Interest rate or foreign currency swap
What is an option contract?
Has the right but not the obligation to buy or sell
What is a futures contract?
Has the right AND the obligation to deliver/purchase foreign currency or goods in the future at a price set today (normally traded on a national exchange)
