F6: M3 Derivatives and Hedge Accounting

Which of the following financial instruments is NOT considered a derivative financial instrument? A. Bank certificates of deposit. B. Stock-index options. C. Interest-rate swaps. D. Currency futures.

A. Bank certificates of deposit. Derivatives includes futures, forwards, options, and swaps. 1) Stock-index options - any other options 2) Interest-rate swaps - currency swaps 3) Currency futures - any other futures.

Grey Co. purchased stock in Cherry Co. Grey purchased a put option on the stock. The strike price is the current market price. What is the most likely reason Grey purchased the put option?

A. Cherry stock has increased in price, but Grey is concerned that the price might decrease. - Put options on stock lock in the sale price of the stock; if the stock decreases in value, the put option holder will have locked in the now higher price. Grey, as the owner of the stock itself and the put option on the stock, will benefit if the stock goes up (and would therefore NOT exercise the option) but also benefit if the stock goes down due to the locked-in sale price from the put. --> A put option allows the investor to benefit from price decreases in the underlying asset. --> Grey would not pay to buy the option if it thought the price would remain flat. --> If an investor believes that the stock price will increase (on a stock already owned), the investor will not purchase an option.

Qualified derivatives may be used to hedge the cash flow associated with an/a:

Asset - YES ; Forecasted transaction - YES A qualified derivative may be used (designated) the 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 fair value hedge).

Which of the following financial instruments may be considered a derivative financial instrument? A. Money market fund. B. Municipal bond. C. Bank certificate of deposit. D. Option contract.

D. Option contract. A derivative represents a contract between parties based on an underlying financial asset. The value of the derivative is driven by the value and activity of the underlying asset. Options, forwards, futures, and swaps are common examples of derivatives. --> Money market fund is a mutual fund that invests in cash, cash equivalents, and other highly liquid investments. --> A municipal bond is a debt instrument representing an amount borrowed by a state government, local government, or other municipality. --> A bank certificate of deposit (CD) is a time deposit where money is kept with the bank for a set period of time, thereby earning a promised return.

What is a derivative financial instrument?

Derivative financial instrument: is a financial instrument that DERIVES its value from the value of some other instrument and has all 3 of the following characteristics: 1) one or more underlyings and one or more notional amounts or payment provisions (or both); 2) it requires no initial investment or one that is smaller than would be required for other types or similar contracts; and 3) its terms require or permit a net settlement (i.e., it can be settled for cash in lieu of physical delivery), or it can readily be settled net outside the contract (e.g., on an exchange) or by delivery of an asset that gives substantially the same results (e.g., an asset readily convertible to cash).

A change in the fair value of a derivative qualified as a cash flow hedge is determined to be either effective in offsetting a change in the hedged item or ineffective in offsetting such a change. How should the effective and ineffective portions of the change in value of a derivative which qualifies as a cash flow hedge be reported in the financial statements?

Effective portion in - Other comprehensive income Ineffective portion in - Current income - Changes in (gains and losses on) the effective portion of a cash flow hedge are deferred and reported in "other comprehensive income." - Changes in the ineffective portion are reported in current income. Gains and losses which are deferred and reported in "other comprehensive income" must be reclassified and recognized in income in the period(s) in which the hedged item affects income.

Neron Co. has two derivatives related to two different financial instruments, instrument A and instrument B, both of which are debt instruments. The derivative related to instrument A is a fair value hedge, and the derivative related to instrument B is a cash flow hedge. Neron experienced gains in the value of instruments A and B due to a change in interest rates. Which gains should be reported by Neron in its income statement?

Gain in value of debt instrument A (fair value hedge) - YES Gain in value of debt instrument B (cash flow hedge) - NO "Fair value hedge" gains and losses are recorded in the Income Statement, while the "cash flow hedge" gain and losses, to the extent they are effective (which is assumed in this fact pattern), are recorded as a component of Other Comprehensive Income.

A derivative designated as a "fair value hedge" must be:

I. Specifically identified to the hedge asset, liability, or unrecognized firm commitment. II. Expected to be highly effective in offsetting changes in the fair value of the hedge item.

A derivative designed as a fair value hedge must be:

I. Specifically identified to the hedged asset, liability, or unrecognized firm commitment. II. Expected to be highly effective in offsetting changes in the fair value of the hedged item. A derivative may be designated & qualify as a fair value hedge if a set of criteria relating to the derivative and the hedged item are met: 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 fair value 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 fair value that could affect income.

What risks are inherent (essential) in an interest rate swap agreement?

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 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. II. Credit risk results from the risk of nonperformance by the counter-party to the agreement (option II). I. Market risk is the risk of exchanging a lower interest rate for a higher interest rate (option I). Thus, both risks I and II are inherent in interest rate swap agreements. SFRAS 108.42.45

How should a U.S. publicly-traded company report a change in fair value of a hedge available-for-sale security attributable to foreign exchange risk if the hedge is a "fair value hedge"?

In earnings. A "fair value hedge" is an instrument designed to hedge the exposure from changes in the fair value of recognized asset or liability. Gains and losses on both the fair value hedge itself and the hedge item are recognized in earnings in the same accounting period. --> Changes in the fair value of the security itself and the fair value hedge are recognized in earnings, NOT in comprehensive income. --> The appropriate accounting treatment is to record changes in the hedged item in earnings, NOT as a contra-asset to the hedge. --> Changes in value for the hedged security DO NOT get recorded as changes to the cost basis of the hedge.

Big Brown Corporation's derivative investments had the following fair values at Dec. 31, Year 1 and Dec. 31, Year 2: 12/31/Year 1 12/31/Year 2 Speculative derivatives $280,000 $310,000 Derivatives used as fair value hedges $600,000 $745,000 Derivatives used as cash flow hedges $430,000 $510,000 The derivatives used as fair value hedges and cash flow hedges were both considered highly effective in Year 2. What amount of gain from these derivative investments should Big Brown report in its Year 2 net income and other comprehensive income?

Net Income $175,000 ; OCI $80,000 Unrealized gains and losses on derivatives with no hedge designation (speculative) and derivatives used as fair value hedges are reported in current earnings. Unrealized gains and losses on the effective portion of derivatives used as cash flow hedges are included in other comprehensive income until the future cash flows associated with the hedge item are recognized. Therefore, the Year 2 gains from Big Brown's derivative investments would be reported as follows: Unrealized gains to be reported in Net Income: Gains on speculative derivatives: ($310,000 - 280,000) = $30,000 Gain on fair value hedges: ($745,000 - 600,000) = 145,000 Total = $175,000 Unrealized gains to be reported OCI: Gains on cash flow hedges: ($510,000 - 430,000) = $80,000

What is the characteristic of a perfect hedge?

No possibility of future gain or loss. - A perfect hedge results in neither gains nor losses. 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.

Gains and losses from changes in the fair value of a derivative designated and qualified as a "fair value hedge" should be:

Recognized in current net income in the period in which the fair value of the derivative changes.

Gains and losses from changes in the fair value of a derivative designated and qualified as a fair value hedge should be:

Recognized in current net income in the period in which the fair value of the derivative changes. - 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. --> NOT recognized as a deferred debit or deferred credit in the balance sheet until the derivative is settled.

How should gains or losses from fair value hedges be recognized?

The gain or loss, along with the offsetting loss or gain attributable to the hedged risk, should be recognized currently in earnings in the same accounting period.

What is a common characteristic of a derivative financial instrument that distinguishes itself from other types of financial instruments?

They have a notional amount or payment provision that is based on the changes in one or more underlying variables.

A derivative financial instrument is best described as:

a contract that has its settlement value tied to an underlying notional amount.

What factors are used to determine the value or settlement amount of a derivative?

1) An underlying, 2) A notional amount For example, a number of shares of stock (the notional amount) x a price per share (the underlying) would give the value or settlement of a derivative with those elements.