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.

Accepted Answer

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 recognized immediately in earnings.

Question 2

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

Accepted Answer

Derivative financial instruments are specifically designed to offset or mitigate risks associated with an underlying asset or investment. They may be used to hedge against market fluctuations, protect against potential losses, or provide other forms of risk management. While these instruments can sometimes be complex and carry their own risks, they are generally intended to provide a way to reduce risk exposure rather than increase it.

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.

Accepted Answer

This is a correct definition of an option on a financial instrument.

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.

Accepted Answer

An options contract used to hedge against price changes in an inventory of supply parts is a fair value hedge, as it is intended to protect against changes in the fair value of an asset or liability.

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.

Accepted Answer

When a futures contract is used to hedge a debt sale, any gain on the debt sale due to lower interest rates will be offset by a loss on the futures position. Thus, the potential benefit of being able to issue debt at a lower interest rate (higher price) will be cancelled out by the loss on the futures position. Therefore, the statement is true.

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.

Accepted Answer

The agreement represents a foreign currency hedge because it is intended to mitigate the risk of fluctuations in the exchange rate between the British pound and the US dollar. By denoting the agreement in US dollars, the British company is essentially locking in the exchange rate at the time of the agreement, thereby reducing the uncertainty of the final cost of the goods to be imported.

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.

Accepted Answer

A futures contract used to hedge the price changes of a forecasted sale of copper is considered a cash flow hedge because it is intended to manage the variability in cash flows associated with the forecasted transaction.

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.

Accepted Answer

The effectiveness of a hedge is dependent on the correlation or closeness of the match between the item being hedged and the financial instrument chosen as a hedge. A closer match will result in a more effective hedge, while a mismatch would lead to a less effective hedge or even losses.

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.

Accepted Answer

An interest rate swap to convert floating-rate debt into fixed-rate debt is a cash flow hedge, not a fair value hedge, as it aims to stabilize cash flows rather than the fair value of the debt.

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.

Accepted Answer

This is the primary criterion for a transaction to qualify as a hedge under accounting standards such as ASC 815 (formerly FAS 133). The transaction must be expected to be highly effective in offsetting changes in the fair value or cash flows of the hedged item or transaction. Other criteria such as formal documentation, effectiveness testing, and ongoing monitoring also apply.

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.

Accepted Answer

An interest rate swap used to convert fixed rate interest into floating rate interest on a held-to-maturity bond is a fair value hedge, as it is used to hedge the exposure to changes in the fair value of the bond due to interest rate fluctuations.

Question 12

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

Accepted Answer

The seller in a futures contract benefits when interest rates rise because the value of the underlying asset typically decreases, allowing them to buy it back at a lower price.

Question 13

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

Accepted Answer

The financial futures market exists to allow participants to hedge or speculate on the future price movements of financial instruments, not to directly buy or sell the underlying 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.

Accepted Answer

All of these are correct. A) A forward contract specifies a particular delivery date, while a futures contract allows the seller to choose a specific date within the designated month. B) Unlike futures contracts, forward contracts are not traded on a market exchange. C) Forward contracts do not require daily cash settlements, and gains and losses are only paid upon completion of the contract.

Question 15

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

Accepted Answer

A gain or loss from a cash flow hedge is first recognized in other comprehensive income (OCI) and then reclassified to earnings in the period when the underlying hedged transaction affects earnings.

Question 16

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

Accepted Answer

Derivatives are financial instruments which derive their value from an underlying asset or index. They can create either asset or liability for the parties involved, depending on whether they have bought or sold the derivative. Therefore, they 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.

Accepted Answer

Hedging can be used to deal with exposure to fair value risk, cash flow risk, and foreign exchange risk. Therefore, all of the answer choices 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.

Accepted Answer

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. Predictable results and fixed outcomes are not criteria for qualifying as a hedge.

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.

Accepted Answer

An interest rate swap is a common tool used to hedge interest rate risk. By converting floating rate debt into fixed rate debt, the company is synthetically creating a fixed rate liability, which can be covered with a fixed rate interest rate swap. This would be considered a cash flow hedge, as the company is hedging against the variability of cash flows due to changes in interest rates.

Question 20

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

Accepted Answer

This statement is true. All derivatives, including both financial and non-financial derivatives, are carried on the balance sheet at fair or market value, either as assets or liabilities. This accounting rule is intended to reflect the economic reality that derivatives represent.

Quiz 22: Appendix a Derivatives

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.

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

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.

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

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.

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

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

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.

Which of the following is not a fair value hedge?

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.

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

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

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

A forward contract differs from a futures contract in that:

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

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

Hedging is used to deal with exposure to:

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

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

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