Deck 22: Appendix a Derivatives

Question 1

If a derivative is not designated as a hedging instrument, or doesn't qualify as one, any gain or loss from fair value changes is not recognized immediately in earnings.

Answer 1

False

Question 2

Derivative financial instruments exist to lessen, not increase, risk.

Answer 2

True

Question 3

An option on a financial instrument-say a Treasury note-gives its holder the right either to buy or to sell the Treasury note at a specified price and within a given time period.

Answer 3

True

Question 4

An options contract to hedge possible future price changes of an inventory of supply parts would:

A)Represent a cash flow hedge.
B)Represent a fair value hedge.
C)Represent a foreign currency hedge.
D)Not qualify as a hedge.

Question 5

If a futures contract is used to hedge a debt sale, and interest rates go down causing debt security prices to rise, the potential benefit of being able to issue debt at that lower interest rate (higher price) will be offset by a loss on the futures position.

Question 6

An agreement by a British company to import manufactured goods from Thailand, denominated in US dollars:

A)Represents a cash flow hedge.
B)Represents a fair value hedge.
C)Represents a foreign currency hedge.
D)Does not qualify as a hedge.

Question 7

A futures contract to hedge possible future price changes of a forecasted sale of copper:

A)Represents a cash flow hedge.
B)Represents a fair value hedge.
C)Represents a foreign currency hedge.
D)Does not qualify as a hedge.

Question 8

The effectiveness of a hedge is influenced by the closeness of the match between the item being hedged and the financial instrument chosen as a hedge.

Question 9

Which of the following is not a fair value hedge?

A)An interest rate swap to synthetically convert fixed-rate debt (for which interest rate changes could change the fair value of the debt) into floating-rate debt.
B)A futures contract to hedge changes in the fair value (due to price changes) of aluminum, sugar, or some other type of inventory.
C)An interest rate swap to synthetically convert floating-rate debt (for which interest rate changes could change the cash interest payments) into fixed-rate debt.
D)All of these are fair value hedges.

Question 10

The key criterion for qualifying as a hedge is that the hedging relationship must be highly effective in achieving offsetting changes in fair values or cash flows.

Question 11

An interest rate swap to synthetically convert fixed rate interest on a held-to-maturity bond investment into floating rate interest:

A)Represents a cash flow hedge.
B)Represents a fair value hedge.
C)Represents a foreign currency hedge.
D)Does not qualify as a hedge.

Question 12

The seller in a futures contract derives a loss when interest rates rise.

Question 13

The financial futures market exists to provide a mechanism to buy and sell the underlying financial instruments.

Question 14

A forward contract differs from a futures contract in that:

A)A forward contract calls for delivery on a specific date, whereas a futures contract permits the seller to decide later which specific day within the specified month will be the delivery date (if it gets as far as actual delivery before it is closed out).
B)Unlike a futures contract, a forward contract usually is not traded on a market exchange.
C)Unlike a futures contract, a forward contract does not call for a daily cash settlement for price changes in the underlying contract.Gains and losses on forward contracts are paid only when they are closed out.
D)All of these are correct.

Question 15

A gain or loss from a cash flow hedge is recognized immediately in earnings.

Question 16

Derivatives create either rights or obligations that meet the definition of assets or liabilities.

Question 17

Hedging is used to deal with exposure to:

A)Fair value risk.
B)Cash flow risk.
C)Foreign exchange risk.
D)All of these are correct.

Question 18

The key criterion for qualifying as a hedge is that the hedging relationship:

A)Must be highly effective in achieving offsetting changes in fair values or cash flows.
B)Must have predictable results.
C)Must have fixed outcomes.
D)None of these.

Question 19

An interest rate swap to synthetically convert floating rate debt into fixed rate debt would:

A)Represent a cash flow hedge.
B)Represent a fair value hedge.
C)Represent a foreign currency hedge.
D)Not qualify as a hedge.

Question 20

All derivatives, no exceptions, are carried on the balance sheet as either assets or liabilities at fair (or market) value.

Question 21

What is a futures contract? A financial futures contract? Provide an example of each.

Question 22

In an annual report to shareholders, Merck & Co., Inc. disclosed the following in regard to its financial instruments:

Question 23

A company recognizes a gain or loss from a fair value hedge:

A)On a deferred basis, with the gain or loss being reported in other comprehensive income in the interim.
B)Within 18 months of the gain or loss from the item being hedged.
C)Immediately in earnings along with the loss or gain from the item being hedged.
D)No gains or losses are reported on fair value hedges.

Question 24

In an interest rate swap on a fixed rate 8% debt of $100,000, where the floating rate is 6%, the annual net interest settlement in cash is:

A)$0
B)$2,000
C)$6,000
D)$8,000

Question 25

Arshan Inc. engaged in an interest rate swap on several of its fixed interest debenture notes in order to hedge against interest rate reduction that would raise the value of its debt. Possibly, investor perceptions may cause the value of the debentures to rise beyond the prices due to changes in general interest rates. If they do, the additional increase in the value of the debt:

A)Would be recorded as an extraordinary loss in that accounting period.
B)Would be recorded as part of continuing operations in that period's income statement.
C)Would be recorded as an unrealized loss in that period's income statement.
D)Would be ignored in that accounting period.

Question 26

In an annual report to shareholders, Merck & Co., Inc. disclosed the following in regard to its financial instruments:

Question 27

How are derivatives reported on the balance sheet? Why?

Question 28

Explain why a stock option is a type of derivative instrument.

Question 29

Which of the following is not an example of a derivative?

A)interest rate swap.
B)cash.
C)stock option.
D)forward contract.

Question 30

The key criterion for qualifying as a hedge is that the hedging relationship must be highly effective in achieving offsetting changes in fair values or cash flows based on the hedging company's specified risk management objective and strategy. Explain what happens if a swap is used ineffectively to hedge the fair value of a note.

Question 31

USA Jewelers' hedge of its net investment in a South African diamond mine:

A)Represents a cash flow hedge.
B)Represents a fair value hedge.
C)Represents a foreign currency hedge.
D)Not qualify as a hedge.

Question 32

An assessment of a hedge's effectiveness must be made:

A)At least monthly.
B)At least every three months.
C)At least every six months.
D)At least annually.

Question 33

How is a gain or a loss from a cash flow hedge reported when it initially occurs? When is it reported in the income statement?

Question 34

Some financial instruments are called derivatives. Why? According to the FASB, should gains and losses on a fair value hedge be recorded as they occur, or should they be recorded to coincide with losses and gains on the item being hedged?

Question 35

To be adequately informed about the adequacy of a company's risk management, investors and creditors need information about strategies for holding derivatives and specific hedging activities. Toward that end, extensive disclosure requirements are required. Identify several of these requirements.

Question 36

A business associate is concerned about the potential effect of hedging transactions on the company's annual earnings. In particular, she is concerned about the company's numerous cash flow hedges. Briefly explain to your associate when a gain or a loss from a cash flow hedge is reported in earnings.

Question 37

Green Import Company held a fixed-rate debt of $4 million. The company wanted to hedge its fair value exposure with an interest rate swap. However, the only notional available at the time on the type of swap it desired was $4.5 million. What will be the effect of any gain or loss on the $500,000 notional difference?

Question 38

To the extent that a fair value hedge is effective in serving its purpose, the gain or loss on the derivative will be offset by the loss or gain on the item being hedged. Explain.