Unit 15 -Derivatives, Hedging & Other Topics Flashcards
Derivatives and Hedging
What is the characteristic of a perfect hedge?
No possibility of future gain or loss.
A hedge is used to avoid or reduce risks by creating a relationship by which losses on certain positions are expected to be counterbalanced in whole or in part by gains on separate positions in another market. A perfect hedge is completely effective. It has a complete negative correlation with the item being hedged and results in no net gain or loss.
Derivatives and Hedging
Which of the following are inherent risks in an interest-rate swap agreement?
Both below:
I. The risk of exchanging a lower interest rate for a higher interest rate
II. The risk of nonperformance by the counterparty to the agreement
An interest-rate swap is an exchange of fixed interest payments for payments based on a floating rate. The risks inherent in an interest-rate swap include both credit risk and market risk.
Credit risk is the risk of accounting loss from a financial instrument because of the possibility that a loss may occur from the failure of another party to perform according to the terms of a contract.
Market risk arises from the possibility that future changes in market prices may make a financial instrument less valuable or more onerous. Market risk therefore includes the risk that changes in interest rates will make the swap agreement less valuable or more onerous.
What is a derivative?
A derivative is a financial instrument or other contract that:
(1) has (a) one or more underlyings and (b) one or more notional amounts or payment provisions, or both;
(2) requires either no initial net investment or an immaterial net investment; and
(3) requires or permits net settlement.
An underlying may be a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable.
A notional amount is a number of currency units, shares, bushels, pounds, or other units specified.
Settlement of a derivative is based on the interaction of the notional amount and the underlying.
A certificate of deposit is a financial instrument of the issuing bank that is a type of promissory note. It has no underlying and requires a material net investment. Thus, it is not a derivative.
Foreign Currency Issues
What is true regarding foreign exchange gains and losses (where the exchange rate is the ratio of units of the functional currency to units of the foreign currency)?
An exchange gain occurs when the exchange rate increases between the date a receivable is recorded and the date of cash receipt.
A foreign currency transaction gain or loss (commonly known as a foreign exchange gain or loss) is recorded in earnings.
When the amount of the functional currency exchangeable for a unit of the currency in which the transaction is fixed increases, a transaction gain or loss is recognized on a receivable or payable, respectively.
The opposite occurs when the exchange rate (functional currency to foreign currency) decreases.
Foreign Currency Issues
What is the functional currency translation approach?
The method used to convert foreign currency amounts into units of the reporting currency is the functional currency translation approach.
It is appropriate for use in accounting for and reporting the financial results and relationships of foreign subsidiaries in consolidated statements.
This method
(1) identifies the functional currency of the entity (the currency of the primary economic environment in which the foreign entity operates),
(2) measures all elements of the financial statements in the functional currency, and (3) uses a current exchange rate for translation from the functional currency to the reporting currency.
The currency indicated by the relevant economic indicators, such as cash flows, sales prices, sales markets, expenses, financing, and intraentity transactions, may not be (1) the currency in which the subsidiary maintains its accounting records,
(2) the currency of the country in which the subsidiary is located, or
(3) the currency of the country in which the parent is located.
Foreign Currency Issues
How are foreign currency transactions recorded?
Foreign currency transactions are recorded at the spot rate in effect at the transaction date.
Transaction gains and losses are included in the income statement in the period the exchange rate changes.
Financial Statement Analysis - Liquidity
What is the effect of write off obsolete inventory during the year on ratio analysis?
Decrease in current ratio but not in quick ratio.
Inventory is included in the numerator of the current ratio but not the quick ratio. Consequently, an inventory write-off decreases the current ratio but not the quick ratio.
Quick ratio: [Excludes inventory]
Cash + ST investments+ net receivables / Current Liabilities
Current ratio: [Includes inventory]
Current Assets / Current Liabilities
Financial Statement Analysis - Activity
How do you calculate the # of days in the operating cycle for the year?
The operating cycle is the time needed to turn cash into inventory, inventory into receivables, and receivables back into cash.
It is equal to the sum of the number of days’ sales in inventory and the number of days’ sales in receivables.
Financial Statement Analysis - Activity
Total Assets Turnover ratio
AR Turnover Ratio
Inventory Turnover Ratio
Total Assets Turnover Ratio = Net Sales / Avg. total assets
AR Turnover Ratio = Net Credit Sales / Avg. Accounts Recv.
Inventory Turnover Ratio = COGS / Avg. Inventory
Financial Statement Analysis - Solvency, Valuation and Comparative Analysis
Rate of return on assets
Rate of return on assets = Net income / Avg. total Assets
Financial Statement Analysis - Solvency, Valuation and Comparative Analysis
How do you calculate book value per share of common stock?
Book value per share of CS =
Net assets aval to common shareholders / ending common shares o/s
& NA aval to common shareholders can also be:
Net assets to common shareholders = Total equity - Liquidation value of Preferred stock
