Hedge Derivities Flashcards
The general criteria for a hedging instrument are that
Sufficient documentation must be provided at the beginning of the process and the hedge must be “highly effective” throughout its life
Hedge accounting is permitted
4 types
1 unrecognized firm commitments
2 available for sale securities
3 foreign currency denominated hedge forecasted transactions
4 net investments in foreign operations
Fair value hedge is a hedge
Of the exposure to change in the fair value of a recognized asset or liability or firm commitment.
Fair value hedge gains and losses are recognized
In the current earnings.
Foreign currency transactions include
Unrecognized firm commitment
Available for sale security
Foreign currency denominated transaction
Net investment in foreign operations
A derivative has three characteristics
1 there is an underlying or notional amount
2 there is little or not initial net investment
3 it’s term requires or permits net settlement
Perfect hedge characteristic
No possibility of future gain or loss
The purpose of Hedge is to reduce exposure to a particular type of risk. A perfect hedge would remove all the risk - remove the possibility of any future gain or loss
At the money
An at the money option is one in which the price of the underling is equal to the strike or exercise price
Bifurcation
The process of separating an embedded derivative from it’s host contract. This process is necessary so that hybrid instruments can be separated into their component parts, each being accounted for using The appropriate valuation technique
Call option
An American call option provides the holder the right to acquire and underlying at an exercise or strike price anytime during the option term. A premium is paid by the holder for the right to benefit from the appreciation in the underlying
Derivative instruments 3 characteristics
1 one or more underlying and one or more notional amounts
2 no initial net investment or a smaller net investment than required for contracts expected to have a similar response to market changes
3 terms that require or permit
A net settlement
B net settlement by means outside the contract
C delivery of an asset that results in a position substantially the same as net settlement
Discount or premium on a forward contract
The foreign currency amount of the contract multiplied by the difference between the contracted forward rare and the spot Tate at the date of inception of the contrast
Embedded derivative
A feature in a financial instrument or other contract which if the feature stood alone would meet the definition of a derivative
Fair value
Defined as the amount at which an asset or liability could be bought or settled in an arm’s length transaction- measured by reference to market prices or estimated by net present value of future cash flows options pricking models or by other techniques
Financial instrument
Financial instruments include cash accounts notes receivable accounts notes payable bonds common stock Preferred stock Stock options Foreign currency forward contracts Future contracts Various financial swaps
Firm commitment
An agreement with and unrelated party, binding on both, usually legally enforceable, specifying all significant terms and including a disincentive for nonperformance sufficient to make performance likely
Foretasted transaction
A transaction expected to occur for which there is no firm commitment and thus which gives the entity no present rights or obligations. Foretasted transactions can be hedged and special hedge accounting can be applied
foreign currency transactions
transactions whose terms are denominated in a currency other than the entity’s functional currency
Forward contract
a forward contract is an agreement between two parties to buy and sell a specific quantity of a commodity, foreign currency, or financial instrument at an agreed upon price with deliver and or settlement at a designated future date.
Forward exchange contract
an agreement to exchange at a specified future date currencies of different countries at a specified rate
Futures Contract
A futures contract is a forward based contract to make or take delivery of a designated financial instrument, foreign currency , or commodity during a designated period, at a specified price or yield.
In the money
a call option is in the money if the prices of the underlying is greater than the strike or exercise price of the underlying
Initial net investment
a derivative instrument is one where the initial net investment is zero or is less than the notional amount.
Intrinsic value
with regard to call (put) options, it is the larger of zero or the spread between the stock (exercise) price and the exercise (stock) price
LIBOR
London Interbank Offer Rate. A widely used measure of average interest rates a a point in time
Notional Amount
The notional amount (or payment provision) is the referenced associated asset or liability. A notional amount is commonly a number of units such as shares of stock principal amount face value stated value basis points barrels of oil
Out of the money
A call option is out of the money if the strike or exercise price is greater than the price of the underlying. A put option is out of the money if the price of the underlying is greater than the strike or exercise price.
Put Option
An american put option provides the holder the right to sell the underlying at an exercise or strike price anytime during the option term A gain accrues to the holder as the market price of the underlying falls below the strike price
Swap
A swap is a forward based contract or agreement generally between two counter parties to exchange streams of cash flows over a specified period in time
Swaption
A swaption is an option on a swap that provides the holder with the right to enter into a swap at a specified future date at specified terms or extend or terminate the life of an existing swap.
Time value
the difference between an option’s price and its intrinsic value
Transaction gain or loss
Transaction gains or losses result from a change in exchange rates between the functional currency and the currency in which a foreign currency transaction is denominated
Underlyings
An underlying is commonly a specified price or rate such as a stock price, interest rate, currency rate, commodity price or related index.
