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302Chapter 18 notes

302Chapter 18 notes - 1 LEARNING OBJECTIVES Derivatives 1...

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1 C HAPTER 18 Derivatives, Contingencies, Business Segments, and Interim Reports L EARNING O BJECTIVES Derivatives 1. Understand the business and accounting concepts connected with derivatives and hedging activities. Uncertainty about the future fair value of assets and liabilities or about future cash flows exposes firms to risk. One way to manage this risk is through the use of derivatives. A derivative is a financial instrument that derives its value from movement of prices, interest rates, or exchange rates associated with an underlying item. Many derivatives are executory contracts, meaning that they are not a transaction but are an exchange of promises about future actions. 2. Identify the different types of risk faced by a business. Of the many types of risk faced by a firm, four important types are: < Price risk . Uncertainty about the future price of an asset. < Credit risk . Uncertainty over whether the party on the other side of a transaction will abide by the terms of the agreement. < Interest rate risk . Uncertainty about future interest rates and their impact on cash flows and the fair value of financial instruments. < Exchange rate risk . Uncertainty about the future U.S. dollar cash flows stemming from assets and liabilities denominated in foreign currencies. 3. Describe the characteristics of the following types of derivatives: swaps, forwards, futures, and options. Swap . Contract in which two parties agree to exchange payments in the future based upon some price or rate. A good example is the exchange of a stream of variable interest payments for a stream of fixed payments. A swap can transform the stream of future cash flows that you have into the cash flow stream that you want. 1
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2 Forward contract . Agreement between two parties to exchange a specified amount of a commodity, security, or foreign currency at a specified date with the price or rate being set now. Forward contracts are usually settled with cash payments instead of by actual delivery of the underlying asset. Futures contract . Very similar to a forward contract, with the difference being that a futures contract is a standardized instrument that is sponsored by and traded on an organized exchange. Option . Contract giving the owner the right, but not the obligation, to buy or sell an asset at a specified exercise price. A call option gives the owner the right to buy an asset; a put option gives the owner the right to sell an asset. The buyer of an option must pay cash in advance for the option; in exchange, the buyer is protected against unfavorable price or rate movements but can still benefit from favorable movements. 4. Define hedging and outline the difference between a fair value hedge and a cash flow hedge. Hedging is the structuring of transactions to reduce risk.
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302Chapter 18 notes - 1 LEARNING OBJECTIVES Derivatives 1...

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