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True / False Questions 1. All derivatives, no exceptions, are carried on the balance sheet as either assets or liabilities at fair (or market) value. TRUE

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

3. 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. TRUE

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

5. 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. TRUE

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

7. 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. FALSE

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

9. 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. TRUE

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

11. An option on a financial instrumentsay a Treasury notegives its holder the right either to buy or to sell the Treasury note at a specified price and within a given time period. TRUE

12. Interest rate swaps exchange fixed interest payments for floating rate payments, or vice versa, without exchanging the underlying principal amounts. TRUE

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Essay Questions Indicate the term that best applies to each of the four transactions described below by placing the letter of the term in the space provided by each transaction. Terms: A. Derivatives B. Hedging C. Futures contract D. Interest rate swaps E. Fair value risk F. Cash flow risk G. Foreign exchange risk H. Fair value hedge

13. ____ A derivative that is used to hedge against the exposure to changes in the fair value of an asset or liability or a firm commitment. H

14. ____ Taking an action that is expected to produce exposure to a particular type of risk that is precisely the opposite of an actual risk to which the company already is exposed. B

15. ____ The exposure to having to pay more cash or receive less cash. F

16. ____ The exchange of fixed interest payments for floating rate payments, or vice versa, without exchanging the underlying principal amounts. D

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Indicate the term that best applies to each of the four transactions described below by placing the letter of the term in the space provided by each transaction. Terms: A. Derivatives B. Hedging C. Futures contract D. Interest rate swaps E. Fair value risk F. Cash flow risk G. Foreign exchange risk H. Fair value hedge

17. ____ Possibility that an investment's value might change. E

18. ____ Financial instruments that derive their values or contractually require cash flows from some other security or index. A

19. ____ An agreement between a seller and a buyer that requires the seller to deliver a particular commodity at a designated future date, at a predetermined price. C

20. ____ Exposure to adverse economic effects from unfavorable changes in currency exchange rates. G

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Multiple Choice Questions 21. 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.

22. 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.

23. 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.

24. 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.

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25. 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.

26. 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.

27. 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.

28. 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.

29. 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.

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30. 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.

31. 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.

32. 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.

33. 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.

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34. 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

35. In an interest rate swap on a fixed rate 8% note payable of $200,000, where the floating rate is 6%, the journal entry to record the annual net cash settlement would be: A.

B.

C.

D.

36. Which of the following is not an example of a derivative? A. interest rate swap. B. cash. C. stock option. D. forward contract.

37. Which of the following is not true about derivatives? A. large losses on derivative investments have been reported in the press. B. derivatives are so named because their value is derived from some underlying measure. C. derivatives are useful instruments for managing risk. D. accounting for derivatives is fully resolved and no additional rules or interpretations are likely.

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Essay Questions On January 1, 2009, Memphis Company borrowed $800,000 from Tiger Bank by issuing a two-year, 10% note, with interest payable quarterly. Memphis entered into a two-year interest rate swap agreement on January 1, 2009, and designated the swap as a fair value hedge. Its intent was to hedge the risk that general interest rates will decline, causing the fair value of its debt to increase. The agreement called for Memphis to receive payment based on a 10% fixed interest rate on a notional amount of $800,000 and to pay interest based on a floating interest rate. The contract called for cash settlement of the net interest amount quarterly. Floating (LIBOR) settlement rates were 10% at January 1, 9% at March 31, and 8% at June 30, 2009. The fair values of the swap are quotes obtained from a derivatives dealer. Those quotes and the fair values of the note are as indicated below.

38. Compute the net cash settlements at March 31, 2009, and on June 30, 2009.

39. Prepare the journal entry to record the issuance of the note on January 1, 2009.

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40. Prepare the journal entries for March 31, 2009.

41. Prepare the journal entries for June 30, 2009.

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Columbus Company borrowed $800,000 from Buckeye Bank by issuing a two-year, 10% note, with interest payable quarterly. Columbus entered into a two-year interest rate swap agreement on January 1, 2009 and designated the swap as a fair value hedge. Its intent was to hedge the risk that general interest rates will decline, causing the fair value of its debt to increase. The agreement called for the company to receive payment based on a 10% fixed interest rate on a notional amount of $800,000 and to pay interest based on a floating interest rate. Floating (LIBOR) settlement rates were 10% at January 1, 9% at March 31, and 8% at June 30, 2009. The fair values of the swap are quotes obtained from a derivatives dealer. Those quotes and the fair values of the note are as indicated below. The additional rise in the fair value of the note (higher than that of the swap) on June 30 was due to investors' perceptions that the creditworthiness of Columbus was improving.

42. Calculate the net cash settlement at June 30, 2009.

43. Prepare the journal entries for interest and the cash settlement on June 30, 2009.

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44. Prepare the journal entry on June 30, 2009, for the change in the fair value of the derivative.

45. Prepare the journal entry on June 30, 2009, for the change in the fair value of the note.

When a note's fair value changes by an amount different from that of a designated hedge instrument for reasons unrelated to interest rates, we ignore those changes. We recognize only the fair value changes in the hedged item that we can attribute to the risk being hedged (interest rate risk in this case).

46. 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. The reasoning is that as interest rates or other underlying events change, a hedge instrument will produce a gain approximately equal to a loss on the item being hedged (or vice versa). These income effects are interrelated and offsetting, so it would be improper to report the income effects in different periods.

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47. 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. Suppose the swap's term had been different from that of the note (say a three-year swap term compared with the 18-month term of the note) or if the notional amount of the swap differed from that of the note (say $500,000 rather than $1 million). In that case, changes in the fair value of the swap and changes in the fair value of the note would not be the same. The result would be a greater (or lesser) amount recognized in earnings for the swap than for the note. Because there would not be an exact offset, earnings would be affected, an effect resulting from hedge ineffectiveness. That is a desired effect of hedge accounting; to the extent that a hedge is effective, the earnings effect of a derivative cancels out the earnings effect of the item being hedged.

48. 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. Objectives and strategies for holding and issuing derivatives. A description of the items for which risks are being hedged. For forecasted transactions: a description, time before the transaction is expected to occur, the gains and losses accumulated in other comprehensive income, and the events that will trigger their recognition in earnings. Beginning balance of, changes in, and ending balance of the derivative component other comprehensive income. The net amount of gain or loss reported in earnings (representing aggregate hedge ineffectiveness). Qualitative and quantitative information about failed hedges: canceled commitments or previously hedged forecasted transactions no longer expected to occur.

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49. 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. Tell your associate not to panic! A gain or loss from a cash flow hedge is deferred as other comprehensive income until it can be recognized in earnings along with the earnings effect of the item being hedged.

50. Explain why a stock option is a type of derivative instrument. Stock options provide the holder with an opportunity to buy shares of stock at a fixed exercise price. As the price of the stock rises, the option becomes more valuable because the spread between the market value of the stock and the exercise price grows. Thus, the value of the option derives from the value of the underlying stock into which it may be exchanged.

51. In an annual report to shareholders, Merck & Co., Inc. disclosed the following in regard to its financial instruments: "While the U.S. dollar is the functional currency of the Company s foreign subsidiaries, a significant portion of the Company's revenues is denominated in foreign currencies. Merck relies on sustained cash flows generated from foreign sources to support its long-term commitment to U.S. dollar-based research and development. To the extent the dollar value of cash flows is diminished as a result of a strengthening dollar, the Company's ability to fund research and other dollar-based strategic initiatives at a consistent level may be impaired. The Company has established revenue hedging and balance sheet risk management programs to protect against volatility of future foreign currency cash flows and changes in fair value caused by volatility in foreign exchange rates." Briefly discuss the possible objectives of the company's revenue hedging program. Merck explains this in the same footnote disclosure, as follows: "The objective of the revenue hedging program is to reduce the potential for longer-term unfavorable changes in foreign exchange to decrease the U.S. dollar value of future cash flows derived from foreign currency denominated sales, primarily the euro and Japanese yen."

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52. In an annual report to shareholders, Merck & Co., Inc. disclosed the following in regard to its financial instruments: "Merck manages its anticipated transaction exposure principally with purchased local currency put options, which provide the Company with a right, but not an obligation, to sell foreign currencies in the future at a predetermined price. If the U.S. dollar strengthens relative to the currency of the hedged anticipated sales, total changes in the options cash flows fully offset the decline in the expected future U.S. dollar cash flows of the hedged foreign currency sales. Conversely, if the U.S. dollar weakens, the options value reduces to zero, but the Company benefits from the increase in the value of the anticipated foreign currency cash flows." Based on this disclosure, briefly explain how Merck should account for any fair value changes in the options mentioned. Merck's discussion suggests the company is treating this as a cash flow hedge. Accordingly, it should defer a gain or loss from a cash flow hedge as part of Other comprehensive income until it can be recognized in earnings along with the earnings effect of the item being hedged. Merck's disclosure added this: "The designated hedge relationship is based on total changes in the options cash flows. Accordingly, the entire fair value change in the options is deferred in Accumulated other comprehensive income (AOCI) and reclassified into Sales when the hedged anticipated revenue is recognized."

53. 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? Such instruments "derive" their values or contractually required cash flows from some other security or index. The FASB has taken the position that the income effects of the hedge instrument and the income effects of the item being hedged should be recognized at the same time.

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54. 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? If interest rates change, the change in the debt's fair value will be less than the change in the swap's fair value. The gain or loss on the $500,000 notional difference will not be offset by a corresponding loss or gain on debt. Any increase or decrease in income resulting from a hedging arrangement would be a result of hedge ineffectiveness such as this.

55. What is a futures contract? A financial futures contract? Provide an example of each. A futures contract is an agreement between a seller and a buyer that calls for the seller to deliver a certain commodity (such as wheat, silver, or Treasury bond) at a specific future date, at a predetermined price. Such contracts are actively traded on regulated futures exchanges. If the "commodity" is a financial instrument, such as a Treasury bill, commercial paper, or a CD, the contract is called a financial futures agreement.

56. How are derivatives reported on the balance sheet? Why? All derivatives without exception are reported on the balance sheet as either assets or liabilities at fair (or market) value. The rationale is that (a) derivatives create either rights or obligations that meet the FASB's definition of assets or liabilities and (b) fair value is the most meaningful measurement.

57. 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? A gain or loss from a cash flow hedge is deferred as other comprehensive income until it can be recognized in earnings along with the earnings effect of the item being hedged.

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