Mod 19 Derivative Key Terms Flashcards
Bifurcation
Process of separating embedded derivative from its host
Contract
At the money
Option where the price of underlying is equal to strike or exercise
Price
Purpose of bifurcation
Separate financial instruments into different components to
Account and valuate appropriately
Derivative instruments are financial instruments or other contracts that have…3 (characteristics)
1 one or more underlyings and notational amounts
2 no initial net investment or smaller net investment than required
Contracts expected to have similar market responses
3 terms that require or permit net settlement
Derivative instruments: terms that require or permit…3
1 net settlement
2 net settlement by outside contract
3 delivery of asset that results in position substantially the same
As net settlement
Discount or premium on a forward contract
Foreign currency amount of contract
multiplied by the difference Between the contracted forward rate
and spot rate at date of inception of contract
Embedded derivative
Feature on financial instrument or contract,
if stood alone would meet definition of derivative
Firm commitment
Agreement with unrelated party, binding both using legally
enforceable, specifying all terms
Includes disincentive for nonperformance, making performance
Likely
Financial instruments include…
Cash, A/R, A/P, bonds, common stock, preferred stock,
Stock options, foreign currency forward contracts, futures
Contracts
Forecasted transaction
Transaction expected to occur where there is no firm commitment
Gives entity no present rights or obligations
Forecasted transactions can be…
Hedged (special hedge accounting can be applied)
3 ways foreign currency transactions arise
1 buy and sell credit goods/services in foreign currency
2 borrow or lend in foreign currency
3 party to unperformed forward exchange contract
Forward contract, an agreement between 2 parties to…
Buy and sell specific commodity, foreign currency, or financial
Instrument at agreed upon price
With delivery and settlement at designated future
A forward contract is…
2) what does this mean?
Not formally regulated by an organized exchange
2) each party to contract is subject to default of other party
Forward exchange contract
Agreement to exchange at specified future date currencies of
Different countries at specified rate
Forward rate
Specified rate
Futures contract
Forward based contract to make or take delivery of designated
Financial instrument, foreign currency or commodity
During designated period at specified price or yield
Futures contract frequently has provisions for…
Cash settlement
Futures contract is traded on…
2) what does this mean?
A regulated exchange
2) involves less credit risk than forward contract
Call option is In the money if…
The price of the underlying is greater than the strike or exercise
Price of the underlying
Derivative instrument is one where the initial net investment is…
Zero or less than the notational amount
Derivative instruments allow the opportunity to take part in…
The rate or price change without owning the asset or liability
If an amount approximating the notational amount must be invested or received it is…
Not a derivative investment
2 basic forms of derivatives instruments
1 futures contracts
2 options
The futures contract involves, what as far as initial net investment?
Little or no initial net investment
Settlement on futures is usually near…
Delivery date
Call options when purchased require a…
Premium payment that is less than cost of purchasing equivalent
Number of shares
Intrinsic value, with regard to call (put) options
Larger of zero or spread between the stock (exercise) price And exercise (stock) price
LIBOR, what does it stand for, define.
London Interbank Offer Rate
Widely used measure of average interest rates at point in time
Net settlements, to qualify as a derivative instrument 1 of the following criteria must be met:
No delivery of an asset equal to…
Notational amount is required
Ex. Interest rate swap does not involve delivery of instrument in
Which notational amount is expressed
Net settlements, to qualify as a derivative instrument 1 of the following criteria must be met:
Delivery of an asset equal to the notational amount is required of one of the parties but…
An exchange facilitates net settlement
Ex. Other market mechanism, institutional arrangement or side agreement facilitates net settlement
Net settlements, to qualify as a derivative instrument 1 of the following criteria must be met:
Delivery by one of the parties of an asset equal to the notational amount is required but the asset is either readily convertible to cash (as with contract for the delivery of a marketable security) or is…
Required but that asset is itself a derivative instrument
Ex. Swaptions
Swaptions
Option to swap
Contract terms based on changes in price or rate of the notational amount, that implicitly or explicitly require or permit…
Net settlement to qualify
Determining if delivery of a financial asset or liability equal to notational amount is a derivative instrument may depend on…
Whether it is readily convertible to cash
Notational amount
Number of units
Ex. Shares stock, principal amount, face value, stated value,
Basis points, barrels of oil
Out of the money,
call option is out of the money if…
The strike price 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
Provides holder the right to sell underlying at an exercise or
Strike price anytime during the option term
Gain accrues to holder as market price of underlying falls below
Strike price
Swap
Forward based contract or agreement between 2 counterparties
To exchange streams of cashflows
over specified period in future
A swaption is an option on a swap that provides the holder with the right to enter into…
A swap at specified future date at specified terms (freestanding
Option on swap)
Or extend or terminate life of existing swap (embedded option
on swap)
Swaption are derivatives that have characteristics of…2
An option and interest rate swap
Time value
Difference between an option’s price and its intrinsic value
Transaction gains or losses result from…
A change in exchange rates between functional currency and
Foreign currency
Transaction gain or loss (foreign currency transactions) represent 2 things
1 actual functional currency cash flows realized upon settlement
Of foreign currency transactions
2 expected functional cash flows on unsettle era foreign currency
Transactions
Underlyings
Commonly specified price or rate (stock price, interest rate,
Currency rate, commodity price, related index)
Anything with changes qualifies unless specifically excluded in
ASC 815
Credit risk
Risk of accounting loss from financial instrument due to Possible
failure of another party to perform according to terms of contract
Off balance sheet risk
Possible amount of loss from instrument that’s not reflected
On balance sheet
Market risk
Risk that future changes in market prices may make financial
Instrument less valuable
