10 - Hedge Accounting

Objective Questions

1. FAS 133 prescribes accounting requirements for
a. Derivative instruments for hedging activities.
b. Debt and equity securities.
c. Fair value measurement.
d. All of the above.

2. Characteristics of a financial derivative instrument include which of the following?
a. Value of the instrument changes in response to underlying.
b. It requires no or comparatively little initial investment.
c. It is to be settled at a future date.
d. All of the above.

3. A financial asset definition does not include
a. Cash.
b. Cash equivalent.
c. Equity instrument.
d. All of the above.

4. On comparing the definition of derivative financial instrument as per U.S. GAAP and IFRS, the only exception highlighted in IFRS is
a. Initial net investment requirement.
b. Future date settlement.
c. Permitting net settlement.
d. None of the above.

5. Which of the standards allows for a shortcut method that assumes perfect effectiveness for certain hedging relationships?
a. IFRS.
b. U.S. GAAP.
c. FAS.
d. None of the above.

6. In FAS 133 which items will not be reported?
a. Reserves and provisions.
b. Income and expense.
c. Partner’s equity.
d. All of the above.

7. Which of the following contracts is not exempted from FAS 133?
a. Derivative instruments.
b. Regular-way security trades.
c. Certain insurance contracts.
d. None of the above.

8. Changes in fair value do not include
a. Changes due to passage of time.
b. Difference in the fair value at the beginning and end of the period.
c. Changes in the accounting period.
d. None of the above.

9. Hedge accounting can be discontinued if
a. The instrument qualifies for speculation.
b. Management wants to change the accounting principles.
c. The derivatives expire.
d. All of the above.

10. If the investor writes a call on the basis of a long position in an underlying asset, it is referred to as a
a. Preferred call.
b. Covered call.
c. Long position call.
d. None of the above.

11. A written option cannot be designated as a hedging instrument unless it is combined with a purchase option and a net premium is paid, according to
a. IFRS.
b. U.S. GAAP.
c. Canadian GAAP.
d. IAS.
e. Not mentioned in any of the above.

12. __________is a number of currency units, shares, bushels, pounds, or other units specified in a contract.
1. Premium.
b. Margin.
c. Notional amount.
d. Collateral amount.
e. Settlement amount.

13. Certain insurance contracts like traditional life insurance contracts and traditional property and casualty contracts are not considered as derivatives, according to
a. FAS 136.
b. FAS 133.
c. IAS 39.
d. FAS 140.
e. IAS 40.

14. A covered call is a situation in which the equity investor writes a call to cover his
a. Long position in an underlying asset.
b. Short position in an underlying asset.
c. Short position in a different equity.
d. Long position in an underlying commodity.
e. Forward risk exposed in the market.

15. Hedging a long position in an underlying is possible by
a. Selling puts.
b. Buying calls.
c. Selling calls.
d. Squaring of short position.
e. Buying puts.

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Theory Questions

1. Define a derivative instrument as per U.S. GAAP and as per IFRS.

2. What combination of underlying shares and options is permissible in hedge accounting?

3. Can options that are written qualify for hedge accounting?

4. Accounting standards do not permit hedge accounting for covered calls. What are the reasons for this prohibition?

5. What is the rationale behind the symmetry of risk reward requirements for hedge accounting?

6. What is the exception to the single fair value measure rule?

7. Is hedge accounting permitted for a delta neutral hedging strategy?

8. Enumerate the trade life cycle for ETOs that are used as a hedge for an underlying position both long calls and long puts.

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• The accounting treatment of call options prima facie will depend upon the intention with which the options are purchased: for hedging or speculation (nonhedging).
• If the position is taken as a hedge against some other position, then the relevant accounting standards will be applicable and there are certain conditions that are to be fulfilled for the same.
• Only long calls and long puts are eligible for hedge accounting, as written calls or puts limit the profitability while exposing the investor to unlimited risks and as such are not eligible for hedge accounting.
• The standards require that the potential for gains should be at least equal to the potential for losses; this is known as a symmetrical risk-reward situation. For a written option the risk-reward is asymmetrical; hence, written options per se do not qualify for hedge accounting.
• However, a combination of written options and certain other derivative instruments that results in a symmetrical risk-reward may qualify for hedge accounting.
• To qualify for hedge accounting, either the upside and downside potential of the net position must be symmetrical or the upside potential must be greater than the downside potential.
• Written options based on symmetry of the gain and loss potential of the combined hedged position qualify for hedge accounting as per the accounting standard.
• If a written option is designated as hedging a recognized asset or liability, the combination of the hedged item and the written option provides at least as much potential for gains (as a result of a favorable change in the fair value of the combined instruments) as it does exposure to losses from an unfavorable change in their combined fair value.
• Hedge accounting is not permitted for covered calls. This prohibition is also specifically mentioned in the standard itself.
• It is permissible to separate the intrinsic value and time value of an option contract, designate as the hedging instrument only the change in intrinsic value of an option, and exclude change in its time value.
• The accounting standards permit an entity to apply hedge accounting for a delta-neutral hedging strategy and other dynamic hedging strategies under which the quantity of the hedging instrument is constantly adjusted in order to maintain a desired hedge ratio.

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