Financial Instruments & Derivatives COPY Flashcards

1
Q

What is a Financial Instrument?

A

1) Cash
2) Ownership interests in an entity (such as stock)
3) Derivative contracts that create a right and obligation to transfer other financial instruments (such as stock options)
“C-O-D”

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2
Q

What are the three main reasons why entities acquire derivatives?

A

1) Investments
2) Arbitrage
3) Hedge

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3
Q

Are derivatives assets or liabilities?

A

Trick question! They can be both.

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4
Q

What value are derivatives reported at?

A

Derivatives are always reported at their FAIR VALUES! (cost upon acquisition, which is effectively Fair Value)

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5
Q

Where are unrealized gains and losses on derivative cash flow hedges recognized?

A

In Other Comprehensive Income (the “D” in “D-E-N-T”; kind of like Available-for-Sale Securities)

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6
Q

Where are unrealized gains and losses on fair value hedges recognized?

A

In Income, along with any offsetting losses or gains on the hedged item (kind of like Trading Securities)

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7
Q

When are all unrealized gains and losses on hedges recognized?

A

In the period of the increase or decrease in value

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8
Q

Derivatives are financial instruments that have what characteristics?

A

1) No net investment
2) An Underlying and Notional Amount
3) A Net Settlement
“N-U-N-S”

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9
Q

Regarding derivatives, what is meant by an underlying amount?

A

The main factor affecting the derivative’s value, such as a specified price, interest rate, or exchange rate

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10
Q

Regarding derivatives, what is meant by a notional amount?

A

The NUMBER of units such as bushels, pounds, or amount of foreign currency (foreign currency units, FCUs)

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11
Q

What derivative contract has the right, but not the obligation to sell shares in the future?

A

A put-option contract

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12
Q

What derivative contract has the right, but not the obligation to acquire shares in the future?

A

A call-option contract

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13
Q

What derivative contract has both the right and obligation to deliver or purchase foreign currency or goods in the future at a price set today?

A

A futures contract

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14
Q

What derivative contract has both the right and obligation to buy or sell a commodity at a future date for an agreed-upon price?

A

A forward contract

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15
Q

What is an agreement between two parties to exchange streams of cash flows over a specified period in the future?

A

An interest rate (or foreign currency) swap

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16
Q

If entering into an interest rate swap, what disclosures (relating to the off-balance sheet risk) need to be made?

A

1) Risk of exchanging a lower interest rate for a higher one

2) Risk that the other bank (party) might default on the agreement (counterparty/default/credit risk)

17
Q

What type of derivative hedges against a recognized asset, liability, or firm purchase agreement?

A

Fair value hedge

18
Q

What type of derivative hedges against a forecasted transaction expected to take place in the future, but which isn’t yet a legal commitment?

A

Cash flow hedge

19
Q

What is a Fair Value Hedge?

A

A derivative that offsets exposure to changes in the value of a recognized asset, liability, or firm purchase agreement

20
Q

What is a Cash Flow Hedge?

A

A derivative that hedges against a forecasted transaction expected to take place in the future, but which isn’t yet a legal commitment

21
Q

How is a Fair Value Hedge recorded?

A

Initially recorded on Balance Sheet at Fair Value

Gains/Losses recorded on Income Statement. Should be offset by loss or gain on hedged item.

22
Q

How is a Cash flow Hedge recorded?

A

Initially recorded on Balance Sheet at Fair Value

Gains/Losses going to OCI.

Example: A cereal company enters into a futures contract on grain purchases to offset the risk that grain will go up in price. No effect on net income until forecasted event/activity occurs.

23
Q

How would Speculation Hedges be recorded?

A

Initially recorded on Balance Sheet at Fair Value

Gains/Losses recorded on Income Statement. Should be offset by loss or gain on hedged item.

24
Q

What is meant by a “Perfect Hedge”?

A

No possibility of future gain or loss

25
Q

What features comprise compound or hybrid instruments such as convertible stock?

A

1) A host instrument (the bond)

2) An embedded derivative (conversion feature)

26
Q

If the host instrument of a hybrid instrument is not reported at fair value, how is the embedded derivative treated (valued)?

A

The embedded derivative would be separated from the host instrument (bifurcation) and accounted for separately?

27
Q

What is it called when separating a derivative from the host instrument and accounting for it separately?

A

Bifurcation

28
Q

How are hybrid instruments usually valued?

A

Usually at fair value since their embedded derivative is required to be valued at fair value

29
Q

What disclosures are required for derivative transactions?

A

1) Objectives and Strategies
2) Context to help investor understand the instrument
3) Risk Management Policies
4) Complete List of Hedged Instruments

30
Q

In order to recognize the transfer of financial instruments as a sale, what conditions must be satisfied?

A

1) Asset must be beyond reach of the transferor and its creditors (“Out of my hands”)
2) The transferor cannot place any restrictions on what the transferee can do with the asset (“No control over its future use”)
3) There is no repurchase or redemption agreement that might allow the transferor to force a return of the asset (“No buyback clauses”)