Question

Derivatives and Hedging:

- What is a derivative and how do you define it? What distinct characteristics make it a derivative, and what are some examples? How is that different than a financial instrument?

- What are the differences in the common types of derivatives I discussed and their characteristics (see examples, discussion, and PP descriptions). For example, could you state what the difference between a future and a forward is?

- What is the point of hedging (as a broader concept) and how is that different from diversification?

- What is the point of qualifying for hedge accounting, and what do you have to to qualify? Though the rules of hedge accounting may be different based on what you are hedging against (fair value vs. cash flow), what is the overall Purpose of qualifying for hedge "accounting"?

- Write out potential journal entries (and the FS line item impacts - e.g. increases and decreases) for a fair value hedge (of an AFS security) and a cash flow hedge (e.g. accounts receivable).

a) what is the net impact to the income statement on both of them during the period the decision is changing value - and with the cash flow hedge in the beginning and at settlement? what is the impact to total equity during these periods (payabley Attention to the cash flow hedge and the effect OCI and income have on equity)? how are they different for fair value vs. cash flow?

b) what would be different in a) if you didn't qualify for hedge accounting?

c) what would be different in the fair value hedge if you were hedging against a trading security? Based on this answer, why might companies be less likely to use hedge "accounting" for a trading security?

Foreign Exchange:

- Review the foreign exchange section of the powerpoint so that you can discuss with a colleague: examples of factors that affect FX rates, what direct vs. indirect rates are, what determines the 'functional' currency of a company, what is the difference between Translation and remeasurement, what are non-monetary accounts, and importantly - what rates would you use for each account in translation vs. remeasurment (eg current, historical, weighted avg)?

Answer 1

- A derivative is like a contract whose value is derived from the prices of their underlying assets.A very distinct characteristic of a derivative is that it is a contract between two parties and it is a zero sum game that is one party's loss is other party's gain.

- The most important difference between a future and a forward is that the the forward is a over the counter contract and a future contract is a very well regulated one with a clearing house.And second difference is that the future is settled every day after the close of the market whereas the forward market is settled only on the expiry date.

- Diversification is a portfolio management strategy which basically reduces a specific risk such as a systematic risk of the financial market.Whereas a hedging strategy reduces the loss by taking an offsetting position.