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FinAcc2 (ch. 16)
Terms in this set (22)
What is a financial instrument?
A contract that creates both a financial asset for one party and a financial liability or equity instrument for the other party.
What is a derivative?
A complex financial instrument that gets its value from an underlying primary financial instrument. They transfer risks that are inherent in the underlying primary investment without either party having to hold any investment in the underlying.
What are three characteristics of derivatives?
1. Their value changes in response to the underlying2. They require little or no initial investment
3. They are settled at a future date
What are three common types of derivatives?
Options, forwards and futures
What does it mean for a derivative to be 'embedded'?
The contract has more than one part: a host (non-derivative) and one or more derivatives.
Why do derivatives exist?
To help companies manage risks by hedging (offsetting risks) or speculating (expecting profit from assumed risk)
What are 3 categories of costs related to derivatives?
1. Direct costs
2. Indirect costs
3. Hidden or opportunity costs
What is 'forex'?
What is the ISDA?
International Swaps and Derivatives Association
What are the different kinds of financial risk, as defined by IFRS?
1. Credit Risk
2. Liquidity Risk
3. Market Risk
a) Currency Risk
b) Interest Rate Risk
c) Other Price Risk
What is a forward contract?
A contract wherein one party agrees to sell to another party at a future time at a fixed price.
What is an arbitrageur?
Someone who plays both sides of a market to exploit inefficiencies caused by information asymmetry.
Why are speculators and arbitrageurs important?
They keep the market liquid on a daily basis.
What are the 3 basic principles regarding accounting for derivatives?
1. They meet the definition of assets/liabilitites, and should be recognized when the entity becomes party to the contract
2. They should be measured at fair value
3. Gains and losses should be booked through net income
Are executory contracts derivatives? When are they recognized?
No, unless they are traded on the market to establish fair value. They are recognized when the non-financial assets are delivered.
What is a net settlement feature in a purchase commitment?
A feature whereby the contract can be settled on a net basis by paying cash or other assets as opposed to taking delivery of the underlying product.
What is an 'exercise' or 'strike' price?
The price at which an option or warrant gives the holder the right to buy or sell the underlying, within a defined term (the exercise period).
What is the difference between purchased and written options?
If a company PURCHASES an option it pays a fee and gains a right to do something. If it WRITES an option, it takes a fee and gives a right to do something.
What is the difference between a 'put' and 'call' option?
A PUT option gives the holder the right to sell the underlying, a CALL option gives the holder the right to buy the underlying.
What is an option's 'intrinsic' value?
The difference between the market price of the underlying and the strike or exercise price at any point in time.
What is an option's 'time' value?
A reflection of the possibility that the option will have a fair value greater than zero because there is some expectation that the price of the underlying will increase above strike price during the option term.
If an option pays off, and is sold before the exercise date, how do you account for the remaining time value?
As a loss.
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