M4 - Derivatives and Hedge Accounting

Question 1

A gain or loss from a forward exchange contract for speculation (e.g., does not relate to a specific transaction) is equal to the difference in the forward rate at the date the contract is purchased and the forward rate at the Balance Sheet date. (true or false)

Answer 1

True

Question 2

True or False: Gains or losses on hedges of firm commitment’s for a future purchase (or sale) be recognized in current income. In addition the firm commitment MUST be adjusted to FV with the resulting gain or loss recognized in current income.

Answer 2

True

The difference between the gain or loss on the hedge contract and the gain or loss on the firm commitment is the net effect on current income.

Question 3

You will use the spot rate if there are still days remaining on the contract instead of using the futures rate. (true or false)

Answer 3

FALSE, you would use the futures rate since there are days remaining on the contract period.

Question 4

SFAS No. 133 defines derivatives for accounting purposes as having one or more underlying’s (and one or more NOTIONAL amounts), and REQUIRING an initial net investment. (true or false)

Answer 4

FALSE, it does NOT require an initial net investment (or having an initial net investment that is smaller than would be required for other types of similar contracts).

Question 5

The value of a derivative is determined by the multiplication (or other arithmetic interaction) of a notional amount and an underlying. (true or false)

Answer 5

True

For example, a number of shares of stock (the notional amount) times a price per share (the underlying) would give the value of the settlement amount of a derivative with those elements.

Question 6

Gains and losses resulting from the change in FV of derivatives designated and qualified as FV hedges should be recognized in net income in the period in which the FV of the derivative changes. (true or false)

Answer 6

True

Any gain or loss for the period on the hedged item also is recognized in net income. If the hedge is fully effective, the gain or loss on the derivative will exactly offset the loss or gain on the hedged item.

Question 7

A qualified derivative may be used to hedge the cash flow associated with

• An asset
• Forecasted transaction
• Both

Answer 7

Both

A qualified derivative may be used (designated) to hedge exposure to variability in cash flow associated with an asset, liability or a forecasted transaction (but not a firm commitment, which would be a FV hedge).

Question 8

A derivative may be designated and qualify as a FV hedge if a set of criteria relating to the derivative and the hedged item are met. The most significant criteria are:

Answer 8

1. There is formal documentation of the hedging relationship between the derivative and the hedged item.
2. The hedge must be expected to be highly effective in offsetting changes in the FV of the hedged item and the effectiveness is assessed at least every 3 months.
3. The hedged item is specifically identified.
4. The hedged item presents exposure to changes in FV that could affect income.

Question 9

An interest rate swap agreement is a financial instrument that is both a contractual right and a contractual obligation to both parties. Such an agreement has an off-balance sheet risk of accounting loss resulting from both CREDIT and MARKET risk. What are examples of those risks?

Answer 9

Credit risk results from the risk of nonperformance by the counter-party to the agreement (option II).

Market risk is the risk of exchanging a lower interest rate for a higher interest rate (option I)

Thus, both risk I and II are inherent in interest rate swap agreements.

Question 10

What are some examples of derivative financial instruments?

Answer 10

Stock index options (options)
Interest-rate swaps (swaps)
Currency futures (futures)

NOT bank certificates of deposit

Derivatives include futures, forwards, options, and swaps.

Question 11

A perfect hedge results in what?

Answer 11

In neither a gain nor loss. In a perfect hedge, the gain or loss on the derivative instrument exactly offsets the loss or gain on the item or transaction being hedged.

Question 12

A derivative financial instrument is best described as a contract that has its settlement value tied to an underlying notional amount. (true or false)

Answer 12

True

A derivative is an instrument that derives its value from the value of some other instrument.

Question 13

A hedge is classified as what if it is being used to hedge the value of the inventory?

Answer 13

Fair value hedge

Even if it says the hedge is considered highly effective it is still a fair value hedge, not a cash flow hedge