Financial Risk Management: Module 7 Accounting For Derivatives and Hedge Relationships

Financial Risk Management
Module 7 Accounting for derivatives and hedge relationships

Question 1
Can an organisation combine derivatives to create a hedged instrument?
a. No, derivatives must be in a hedge relationship on a stand-alone basis.
b. Yes, derivatives can be combined, provided that part of the combination is in a highly effective
hedgerelationship.
c. Yes, any derivatives can be combined.
d. Yes, any derivatives can be combined, provided the entire combination is in a highly effective hedge
relationship for the attributablerisks.
Question 2
Assume a derivative is used in a hedge relationship. What is the organisation able to do to divide components
of the derivative to improve the hedge relationship?
a. Split a derivative on a time basis to improve the effectiveness of the hedge.
b. Remove the time value component of an option or forward contract.
c. Remove the time value and split on a time basis.
d. An organisation can never divide components of a derivative in a hedge relationship.
Question 3
In assessing the hedge relationship, can an organisation exclude time value from a derivative?
a. No, time value must never be excluded in assessing the hedge relationship.
b. Yes, time value must be excluded in the assessment of the hedge relationship.
c. Time value can be excluded for certain derivatives if it provides a better effectiveness measure and is
documentedaccordingly.
d. Part of the assessment process every period is to determine whether time value is included or excluded.
Question 4
If the forecast transaction is no longer probable, should an organisation transfer the gains and losses out of
equity to the profit and lossaccount?
a. Only if the derivative is terminated.
b. Only if it is a cash flow hedge.
c. This depends on the hedge relationship.
d. Yes, always.
Question 5
Can an organisation hedge a derivative with another derivative and qualify for hedge accounting?
Module 7 Accounting for derivatives and hedge relationships (FRM)
Semester 2, 2013 Page 1
a. Only for interest rate risk.
b. Never.
c. Only as a combination hedge.
d. Only if settlement dates of both hedges match.
Question 6
Which of the following must an organisation document in relation to a cash flow hedge?
I. Hedged instrument, hedged item, hedged risk.
II. Type of hedge, inclusive or exclusive of time value and effectiveness assessment method.
III. Objective and strategy.
IV. Basis for the transaction being highly probable.
a. I only.
b. II only.
c. I, II and III only.
d. I, II, III and IV.
Question 7
Which of the following risks can be hedged for financial assets and liabilities?
I. Overall fair value risk.
II. Credit risk.
III. Interest-free rate or benchmark interest rate risks.
IV. Foreign currency risk.
a. I, II and III only.
b. I, II and IV only.
c. II, III and IV only.
d. I, II, III and IV.
Question 8
Assume an organisation had forecast sales of oil at a floating price in USDs, and has entered into a cash flow
hedge to fix the cash flow in AUDs. What risk is the organisation hedging?
a. Foreign exchange risk.
b. All risk other than foreign exchange.
c. All risk including foreign exchange.
d. The transaction would not qualify as a risk that is able to be hedged.
Question 9
Can an organisation hedge interest-rate risk for held-to-maturity financial assets?
a. Yes, provided the hedge is highly effective.
b. Yes, but only when it is denominated in foreign currency.
c. No, it is not a permissible hedge.
d. No, as it will never be highly effective.
Question 10
Can an Australian organisation use a USD loan to hedge a firm commitment to receive USDs as a cash
flowhedge?
a. No, as only derivatives can hedge foreign currency risk.
b. No, as this would be a fair value hedge.
c. Yes, but only foreign exchange risk.
d. Yes, but would cover all risks of the firm commitment.
Question 11
If a cash flow hedge is discontinued but the underlying continues to exist, what happens to the deferred hedge
gains andlosses?
a. The deferred gains and losses remain in equity until the underlying hedge item transaction is recorded in
the profit and loss.
b. The deferred gains and losses are taken to the profit and loss immediately.
c. In a cash flow hedge, the gains and losses on the hedge instrument will already be recorded in the profit
and loss.
d. The deferred gains and losses remain in equity as long as the hedge instrument continues to exist.
Question 12
If an organisation hedges variable-rate debt with an interest-rate swap, would it be a cash flow hedge or a fair
value hedge?
a. It is a cash flow hedge attributable to interest-rate risk.
b. It is a fair value hedge attributable to interest-rate risk.
c. It is a cash flow hedge attributable to all risks.
d. It will not qualify as a cash flow hedge because credit risk is not hedged.
Question 13
If an organisation hedges fixed-rate debt, would it be applying a cash flow or fair value rate hedge?
a. Fair value hedge of all fair value changes.
b. Fair value hedge of interest rate risk.
c. Fair value hedge of just credit risk depending on the hedge documentation.
d. Cash flow hedge.
Question 14
Is a foreign exchange hedge of a firm commitment treated as a cash flow or a fair value hedge?
a. A firm commitment can be a fair value or cash flow hedge for foreign currency risk.
b. A firm commitment is always a fair value hedge for foreign currency risk.
c. A firm commitment exposes the profit and loss to cash flow variability and, hence, is a cash flow hedge.
d. A firm commitment can be a fair value or a cash flow hedge for any risk.
Question 15
Is a parent company able to hedge future profits from a subsidiary?
a. Yes, it will be a cash flow hedge.
b. No, because profits are a net outcome of different transactions.
c. Yes, it will be a fair value hedge.
d. Yes, if it is part of the net investment in a foreign operation.
Question 16
How would an organisation determine whether or not a cash flow hedge is highly effective?
a. Assess whether the cash flow of the hedge instrument will offset the hedged item within a range of
80per cent to 125per cent.
b. Assess whether the fair value changes of the hedge instrument and the hedged item will offset.
c. Use regression analysis to measure whether there is any correlation between the two variables.
d. Use the dollar offset method to assess whether any of the cash flows offset.
Question 17
When is a fair value hedge highly effective?
a. The fair value changes of the hedge instrument offset the fair value changes of the hedged item within a
range of 80percent to 125per cent.
b. The fair value of the hedged instrument must equal the hedged item within a range of 80 per cent to
125per cent.
c. The fair value changes of the hedge instrument almost fully offset the fair value changes of the
hedgeditem.
d. Most of the time, the fair value changes of the derivative equal the fair value changes of the hedged item.
Question 18
Must an organisation assess the effectiveness of a hedge if it knows from the outset that the hedge will be
highlyeffective?
a. If the organisation assesses the hedge to be highly effective at inception, that is sufficient.
b. If the organisation expects the hedge to be ineffective, the company must assess it regularly.
c. The organisation must assess the effectiveness of all hedges each reporting period.
d. The organisation must assess the hedge for effectiveness when the hedged item is no longer probable.
Question 19
If a cash flow hedge is no longer highly effective, what would an organisation do with the gains and losses on
the derivative in equity from the previous period?
a. Gains and losses in equity should be written off immediately.
b. Gains and losses can continue to be deferred in equity as long as the derivative exists.
c. Gains and losses up to the previous period prior to the hedge no longer being highly effective can
continue to be deferred to match the underlying hedged item.
d. No gains and losses can be deferred in equity as the hedge is not highly effective.
Question 20
Which of the following prospective methods of assessing effectiveness are acceptable under IAS 39?
I. Regression.
II. Match term.
III. Dollar offset.
a. I and II only.
b. I and III only.
c. II and III only.
d. I, II and III.
Question 21
Which of the following contracts would be excluded from the scope of IAS 39?
a. A foreign exchange contract.
b. An interest rate swap.
c. A commodity contract that is physically delivered.
d. A commodity contract that is net settled prior to delivery.
Question 22
Company ABC issues a floating-rate debt. To protect itself against rising interest rates, the debt contract
stipulates that the interest payable is capped at 8per cent. Which of the following best describes the
debtcontract?
a. The floating-rate debt in combination with the interest rate cap is a hybrid instrument and, therefore,
must be fairvalued.
b. The host contract is a straight floating-rate debt and the clause that caps the interest payable is an
embedded derivative. Theembedded derivative must be separately valued.
c. The host contract is a straight floating-rate debt and the clause that caps the interest payable is an
embedded derivative. Theembedded derivative may be required to be separately valued.
d. The interest cap is not an embedded derivative because it does not satisfy the definition of a derivative.
Question 23
Company XYZ, an Australian company, leases property from Company ABC, a New Zealand company.
Thelease payments are denominated in NewZealand dollars. The functional currency of XYZ is the Australian
dollar; and the functional currency of ABC is the NewZealanddollar. Which of the following best describes the
lease contract?
a. There is no need to investigate the existence of an embedded derivative as the contract is for a purchase
of a non-financial item.
b. The embedded derivative is a foreign currency forward contract and must be valued separately.
c. This is not an embedded derivative because the New Zealand dollar is the functional currency of
Company ABC.
d. The embedded derivative is a currency forward contract but does not have to be valued separately,
asitis closelyrelated to the host contract, in that it has the same functional currency as that of
CompanyABC.
Question 24
An Australian clothing company (ABC Ltd) has recently entered into a contract to purchase 50 000 T-shirts for
USD 100 000 from a US clothing supplier (XYZ Ltd). ABC Ltds functional currency is the AUD and the
functional currency of XYZ is the USD.
Which of the following statements is correct from the perspective of ABC Ltd with regard to the accounting
treatment of embedded derivatives in this contract?
a. There is an embedded derivative component in this contract in the form of an FEC that does not need to
be separately accounted for as the payment made for this contract is made in the functional currency of
XYZ Ltd.
b. There is an embedded derivative component in this contract in the form of an FEC that does not need to
be separately accounted for as the payment made for this contract is made in the functional currency of
ABC Ltd.
c. There is an embedded derivative component in this contract in the form of an FEC that needs to be
separately accounted for.
d. There is no embedded derivative component in this contract, therefore no separate accounting treatment
is necessary.

Solutions
Question 1
Correct Answer: d
Derivatives can be combined to form a hedging instrument, provided the entire combined derivative is in a
highly effective hedgerelationship.
You can review this topic area in the study materials under the section entitled What qualifies as a hedge
instrument?.
Question 2
Correct Answer: b
One of the rules in hedge accounting is that the derivative must be used in its entirety in the hedge relationship.
Theonly exception is that an organisation can choose whether to include or exclude the time value component.
instrument?.
Question 3
Correct Answer: c
If an organisations hedge documentation states that the hedge relationship, being the hedging instrument and
the hedged item, isexcluding the time value of the hedge instrumentmeaning its highly effective, then it is
appropriate that time value be excluded from any future assessment of thehedge.
Time value can only be excluded from option and forward contracts, and it would only be excluded to provide a
better effectivenessmeasure.
instrument?.
Question 4
Correct Answer: d
In a cash flow hedge of a forecast transaction, if the forecast is no longer probable, all gains and losses deferred
in equity must be immediately transferred to the profit and loss.
You can review this topic area in the study materials under the section entitled The hedged item.
Question 5
Correct Answer: b
An organisation can never hedge a derivative with another derivative, as a derivative is not a permissible
hedgeitem.
Question 6
Correct Answer: d
In respect of documentation, a description of all of the following items is essential
I hedge instrument;
I hedge item;
I type of hedge;
I inclusion or exclusion of time value;
I objective;
I strategy; and
I method of assessing effectiveness.
In addition, if an organisation hedges a forecast transaction, it must document the basis of it being
highlyprobable.
A firm commitment is a legally binding agreement. Hence, in the case of a firm commitment it is not necessary to
document the basis for the transaction being highly probable.
You can review this topic area in the study materials under the section entitled Cash flow hedge.
Question 7
Correct Answer: d
In respect of financial assets and liabilities, the hedge risk can be a portion of the risk of the change in cash flow
or fair value provided it is identifiable and separately measurable. Hence, a financial asset or liability could be
hedged for
I overall fair value risk;
I a benchmark interest rate or risk-free interest rate;
I credit risk; or
I foreign exchange risk.
You can review this topic area in the study materials under the section entitled The hedged risks.
Question 8
Correct Answer: c
The risks that can be hedged for a non-financial asset or liability are more restricted and are limited to hedging
I all cash flows or fair value changes; or
I foreign currency risks.
When hedging both price risk and exchange risk, the organisation would be hedging all cash-flow risk or,
inother words, allrisks including foreign exchange.
Question 9
Correct Answer: c
IAS 39 does not permit held to maturity (HTM) investments to be hedged for interest rate risk. The reason for
the HTMclassification is that the organisation is comfortable in holding the assets to maturity and receiving the
fixed yield to maturity on theseinvestments.
You can review this topic area in the study materials under the section entitled The hedged risks.
Question 10
Correct Answer: c
Financial assets and liabilities are permissible hedged items in fair value and cash flow hedges.
IAS 39 also permits a firm commitment to be hedged as a fair value or a cash flow hedge; however, the cash flow
hedge can only qualify when the risk being hedged is foreign exchange risk.
You can review this topic area in the study materials under the section entitled A firm commitment.
Question 11
Correct Answer: a
If a cash flow hedge is discontinued at a point in time, the hedge will still be effective up until that point in time.
Accordingly, gains and losses up to the point when the hedge was discontinued should remain in equity until
the underlying transaction is recorded in the profit and loss.
Question 12
Correct Answer: a
With variable-rate debt, the organisation is exposed to variable cash flows that ultimately affect the profit and
loss. Accordingly, the nature of the swap is that it seeks to convert the variable cash exposure into a fixed cash
flow. Hence, it is a cash-flowhedge.
You can review this topic area in the study materials under the section entitled Cash flow hedge and
Accounting for fair value hedges.
Question 13
Correct Answer: b
When hedging fixed-rate debt, the organisation is hedging the fair-value changes of the debt attributable to the
benchmark interest-raterisk.
You can review this topic area in the study materials under the section entitled Cash flow hedge and
Accounting for fair value hedges.

Question 14
Correct Answer: a
A firm commitment can be considered as creating an exposure to fair value changes or as creating an exposure to
cashflow changes at settlement. Accordingly, IAS 39 permits a firm commitment to be hedged as a fair value or
cash flowhedge.
Question 15
Correct Answer: b
IAS 39 permits organisations to hedge their net investment in a future operation. However, it does not permit
hedging of futureprofits.
You can review this topic area in the study materials under the section entitled Accounting for hedges of net
investments in a foreign operation.
Question 16
Correct Answer: a
The definition of a highly effective cash flow hedge is that the cash flows of the hedge instrument offset the
cash flows of the hedged item in a range of 80per cent to 125per cent.
You can review this topic area in the study materials under the section entitled Hedge effectiveness.
Question 17
Correct Answer: a
By definition, a fair value hedge is highly effective when the fair value changes of the hedge instrument offset
the fair value changes of the hedged item in a range of 80 per cent to 125 per cent.
Question 18
Correct Answer: c
IAS 39 requires the organisation to assess each hedge prospectively and retrospectively at each reporting
period. Accordingly, even a perfect hedge must be assessed prospectively as to whether any of the critical
terms have changed or whether the counter party is no longer capable of settling the transaction. In regard to
the retrospective hedge, the organisation must calculate the quantum of ineffectiveness.

Question 19
Correct Answer: c
Gains and losses on a cash flow hedge can be deferred in equity as long as the hedge is highly effective.
Assoon as the hedge is no longer highly effective, subsequent gains and losses must be recorded directly in
the profit and loss.
Question 20
Correct Answer: d
IAS 39 does not specify a single method of assessing effectiveness. Hence, all of the quoted methods
areacceptable.
You can review this topic area in the study materials under the section entitled Assessing effectiveness
prospectively.
Question 21
Correct Answer: c
Commodity contracts that are physically delivered as part of the companys normal usage of sales requirements
are excluded from the scope of IAS 39.
You can review this topic area in the study materials under the section entitled IAS 39 Financial Instruments:
Recognition and Measurement.
Question 22
Correct Answer: c
The interest cap is an embedded derivative because it satisfies the definition of a free-standing derivative.
However,the cap may be considered to be closely related to the host debt contract provided that the cap rate
of 8 per cent is at or above the market interest rate at the time the debt was issued. If so, the cap is not
separatelyvalued.
You can review this topic area in the study materials under the section entitled Embedded derivatives.
Question 23
Correct Answer: d
The host contract is a non-financial instrument. The embedded derivative is a foreign currency forward and is
closely relatedbecause it
I is not leveraged;
I does not contain an option; and
I requires payment denominated in a currency of the primary economic environment in which a substantial
party to the contract operates (Company ABC).
You can review this topic area in the study materials under the section entitled Embedded derivatives.
Question 24
Correct Answer: a
There is an embedded derivative in the form of a foreign exchange forward exchange contract for AUD and USD.
However, as per the special exceptions provided by IAS39 with regards to embedded derivatives, we can
identify that the payments are made in a functional currency of a substantial party to the contract. USD is the
functional currency of the US clothing company (XYZ Ltd).
In determining whether this contract needs to be separated or not, you can review this topic area in the study
materials under the sections entitled Do embedded derivatives need to be separated? and Special exception
provided by the standard.

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Module 7 Accounting for derivatives and hedge relationships

Module 7 Accounting for derivatives and hedge relationships (FRM)

Module 7 Accounting for derivatives and hedge relationships (FRM)

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