Functional communications will happen between the functional consultants

As discussed with you, please inform the KPMG team that all documents such as updated user manuals, data masters, templates for open transactions/ back log data must go through me in order to achieve the proper archiving. However, report feedbacks and other regular/ functional communications will happen between the functional consultants & key/ super users only. This is FYI and necessary actions only.

PS: Finance, Payroll & HR is already on track in this regard. We should also follow the same and share the message with relevant key/ super users. Looking forward to your cooperation in this regard. 

I don’t think we need to forward as I have already asked the personnel copied in my previous email to share the information with all relevant key/ super users. Dev can share the same with SCM , EAM and Head of QAs respectively. Thanks for your concerns by the way. Good day.

I will request you to schedule the above meeting tomorrow at 10.30 am to 12.30 pm. Please involve the key users from all the departments including SCM, OPM, FIN, HR & PAYROLL, EAM, Projects.

Considering the availability of majority of the super/ key users, I have scheduled the meeting on the 30th April, 2014 (Wednesday) as mentioned in the tabular format below. Thanks.


Please read the message from KPMG below and join the session as mentioned in the tabular format. Do forward this email to others concerned if necessary for invitation. Looking forward in seeing you in the session. 

Bounded rationality describes the limitations of rationality

27. According to Change Competency: Shoes For Crews Reduces Risk and Uncertainty, which of the following has been a result of the warranty implemented by Shoes For Crews?:

a.	Shoes For Crews sales increased 3-fold within the first year of implementing the program.
b.	Shoes For Crews initially suffered great financial loss, but have successfully recovered.
c.	50% of US employees wear Shoes for Crews brand.
d.	9 of the 10 largest restaurant chains in the country either buy the Shoes For Crews brand for their employees or urge them to do so.

ANS:  D                  

   28.   ____ describes the limitations of rationality and emphasizes the decision-making processes often used by individuals or teams.

a.	Satisficing
b.	Temporal immediacy
c.	Bounded rationality
d.	Concentration of effort

ANS:  C                     

   29.   ____ is the tendency to select an acceptable, rather than optimal, goal or decision.

a.	Satisficing
b.	Satisfying
c.	Settling
d.	Resting

ANS:  A                        

   30.   The ____ is among the four basic models of organizational decision making.

a.	tacit model
b.	bounded rationality model
c.	lateral model
d.	dynamic model

ANS:    B

Accounting for a Fair Value Hedge

Accounting for a Fair Value Hedge. If the derivative instrument and the hedged item satisfy the above criteria, then the fair value hedge will qualify for special accounting. The gain or loss on the derivative instrument will be recognized currently in earnings, along with the change in value on the hedged item, and an appropriate adjustment to the basis of the hedged item will be recorded. If the cumulative change in the value of the derivative instrument does not exactly offset the cumulative change in the value of the hedged item, the difference is recognized currently in earnings.

Examples of fair value hedges against inventory, a firm commitment, and a fixed interest notes payable follow. Entries for the transaction/commitment are presented side by side with entries for the hedges. All transaction costs are ignored. The examples include the use of derivatives in the form of a futures contract, forward contract, and swap. Note, however, that other types of derivatives could have been used in some of these examples.

The special accounting treatment given a fair value hedge should continue unless:

• The criteria necessary for special accounting treatment are no longer satisfied,

• The derivative instrument expires or is sold, terminated, or exercised,

• The entity no longer designates the derivative instrument as a fair value hedge, or

• The hedging relationship is no longer considered highly effective based on management’s policies.

Disclosures Requirements of Derivative Instruments

The FASB requires entities that hold or issue derivative instruments to disclose the purpose for holding or issuing such instruments, the context needed to understand the objectives, and strategies for achieving the objectives. With respect to derivative instruments that are designated as hedges, the FASB calls for the following disclosures:

1. The objective of using hedging instruments and the strategies for achieving the objective.
2. Descriptions of the various types of hedges, such as fair value hedges and cash flow hedges.
3. A description of the entity’s risk-management policy for hedging types, along with a description of the types of transactions that are hedged.

In addition, specific disclosures for fair value hedges include the following:
1. The current period effect on earnings traceable to hedge ineffectiveness, the portion of gain or loss excluded from the assessment of hedge effectiveness, and where net gains or losses are reported on the income statement.
2. The amount of gain or loss recognized in earnings when a firm commitment no longer qualifies as a fair value hedge.

For a cash flow hedge, specific additional disclosures include the following:
1. The current period effect on earnings traceable to hedge ineffectiveness, the portion of gain or loss excluded from the assessment of hedge effectiveness, and where net gains or losses are reported on the income statement.
2. The transactions or events that will result in reclassification of OCI to earnings and the amount to be reclassified within the next 12 months.
3. For other than variable interest rate hedges, the maximum length of time over which forecasted transactions are being hedged.
4. The amount of gains or losses reclassified as earnings, because it is probable that a forecasted transaction will not occur.Certain other disclosures are required for hedges relating to an investment in a foreign operation.

4 key points regarding Fair value and Cash flow Hedges

• Fair value hedges apply to recognized assets and liabilities or firm commitments. The terms, prices, and/or rates for these items are fixed. Therefore, changes in the prices or rates affect the fair value of the recognized item or commitment.

• Cash flow hedges apply to existing assets or liabilities with variable future cash flows andto forecasted transactions. The prices or rates for these items are not fixed, and, therefore,future cash flows may vary due to changes in prices or rates.

• In a fair value hedge, both the derivative instrument and the hedged item are measured at fair value. Changes in the fair value of the respective items are recognized currently in earnings.

• In a cash flow hedge, the derivative instrument is measured at fair value with changes in value being recognized in other comprehensive income. The amounts in other comprehensive income are recognized in current earnings in the same period(s) as are the gains or losses on the hedged cash flow.

Accounting for a Cash Flow Hedge

If the derivative instrument and the hedged item satisfy the qualifying criteria, then the cash flow hedge will qualify for special accounting. The gain or loss on the derivative instrument will be reported in other comprehensive income (OCI),7 and the ineffective portion, if any, will be recognized currently in earnings. As with fair value hedges, a portion of the derivative instrument’s gain or loss may be excluded from the assessment of effectiveness. That portion of the gain or loss will be recognized currently in earnings rather than as a component of other comprehensive income.

The gain or loss on a cash flow hedge is reported as OCI, rather than recognized currently in earnings, because the hedged forecasted cash flows have not yet occurred or been recognized in the financial statements. The hedge is intended to establish the values that will be recognized once the forecasted transaction occurs and is recognized. Once the forecasted transaction has actually occurred, the OCI gain or loss will be reclassified into earnings in the same period(s) as the forecasted transaction affects earnings. 

 

For example, assume that a forecasted sale of inventory is hedged. Once the inventory is sold and recognized in earnings, the applicable amount, the OCI gain or loss, will also be recognized in earnings. If the forecasted transaction were a purchase of a depreciable asset, the applicable portion of the OCI would be recognized in earnings when the asset’s depreciation expense is recognized.

Qualifying Criteria for Cash Flow Hedges

As is the case with a fair value hedge, special hedge accounting is not available for a cash flow hedge unless a number of criteria are satisfied. Cash flow hedges must also meet the criteria regarding documentation and assessment of effectiveness. Although set forth in greater detail in the FASB’s Statements of Financial Accounting Standards,8 selected qualifying criteria for a cash flow hedge are set forth in below

1. At inception of the hedge, there must be formal documentation of the hedging relationship and the entity’s risk-management objective and strategy. Documentation should also identify the hedging instrument, the hedged transaction, the nature of the risk being hedged, and a plan for assessing the effectiveness of the hedge.

2. Both at inception and on an ongoing basis, the hedging relationship must be assessed to determine if it is highly effective in achieving offsetting cash flows attributable to the hedged item’s fair value. The effectiveness of the hedging instrument must be assessed whenever financial statements or earnings are reported and at least every three months.

3. If a hedging instrument is used to modify variable interest rates on a recognized asset or liability to another variable interest rate (such instruments are known as basis swaps), the hedging instrument must be a link between a recognized asset with variable rates and a recognized liability with variable rates. For example, an entity with a variable rate loan receivable (e.g., prime rate 1%) and a variable rate loan payable (e.g., LIBOR) may use a hedging instrument (e.g., swap prime rate 1% for LIBOR) to link the two variable rate instruments.

4. The forecasted transaction is specifically identified as a single transaction or a group of individual transactions.

5. The forecasted transaction is with an external party, probably will occur, and presents exposure to variability in cash flows that could affect earnings.

6. The forecasted transaction is not the acquisition of an asset or incurrence of a liability that will subsequently be measured at fair value with changes in fair value being currently recognized in earnings. If the forecasted transaction relates to a recognized asset or liability, such asset or liability is not remeasured with changes in fair value being reported in current earnings.

7. For the forecasted purchase or sale of a nonfinancial item (such as inventory), the risk being hedged against is the change in cash flows due to price/rate changes rather than a change in cash flows due to a different location or a component part.

8. The forecasted purchase or sale of a financial asset or liability (or the interest payments on that asset or liability) or the variable cash flows associated with an existing financial asset or liability can be designated as a hedged item if certain types of risks, such as those related to changes in cash flows, benchmark interest rates, foreign currency exchange rates, and creditworthiness are being hedged. Two or more of the above risks may be hedged simultaneously. Prepayment risk may not be designated as the risk being hedged

Qualifying Criteria for Fair Value Hedges

In order to qualify for special fair value hedge accounting, the derivative and the hedged item must satisfy a following number of criteria.

1. At inception of the hedge, there must be formal documentation of the hedging relationship and the entity’s risk-management objective and strategy. Documentation should also identify the hedging instrument, the hedged transaction, the nature of the risk being hedged, and a plan for assessing the effectiveness of the hedge.

2. Both at inception and on an ongoing basis, the hedging relationship must be assessed to determine if it is highly effective in offsetting the risk exposure associated with changes in the hedged item’s fair value. The effectiveness of the hedging instrument must be assessed whenever financial statements or earnings are reported and at least every three months.

3. The hedged item is specifically identified as part or all of a recognized asset, recognized liability, or unrecognized firm commitment. The hedged item may be a single asset or liability or a portfolio of similar assets or liabilities.

4. The hedged item has exposure to changes in fair value, due to the hedged risk, that could affect earnings. For example, decreasing prices could affect an existing inventory of materials and result in lower gross profits.

5. The hedged item is not an asset or liability that is being measured at fair value, with changes in fair value, both positive and negative, being currently recognized in earnings. For example, an investment in securities, classified as a trading portfolio, would not qualify for special hedge accounting. The unrealized gains and losses on the portfolio would already be recognized in earnings, and changes in the value of a designated derivative would also be recognized currently in earnings. Therefore, special hedge accounting would only be allowed if generally accepted accounting principles (GAAP) do not already require the hedged item to be measured at fair value.

6. For nonfinancial assets (such as inventory) or liabilities, the risk being hedged against is the change in value of the entire item at its actual location rather than a change in value due to a different location or a component part. Therefore, you could not hedge an inventory of butter by designating price changes of milk as the risk being hedged.

7. Financial assets or liabilities and nonfinancial commitments with a financial component can be designated as hedged items if certain types of risks, such as those related to benchmark interest rate risk, foreign currency exchange rates, and creditworthiness are being hedged. Two or more of the above risks may be hedged simultaneously. Prepayment risk may not be designated as the risk being hedged.

Different types of Hedges in Derivatives

A derivative may be used to avoid the exposure to risk by hedging against an unfavorable outcome associated with rate/price changes. Hedges are classified as either fair value or cash flow. 

 

A fair value hedge is used to offset changes in the fair value of items with fixed prices or rates. Fair value hedges include hedges against a change in the fair value of

• A recognized asset or liability.

• An unrecognized firm commitment.

A cash flow hedge is used to establish fixed prices or rates when future cash flows could vary due to changes in prices or rates. Cash flow hedges include hedges against the change in cash flows associated with

• A forecasted transaction.

• An existing asset or liability with variable future cash flows.

Derivative instruments are frequently used as hedges with respect to the exposure to risk associated with foreign currency transactions and investments in foreign companies.

What is a swap?

Swaps. A swap is a type of forward contract represented by a contractual obligation, arranged by an intermediary that requires the exchange of cash flows between two parties. Swaps are customized to meet the needs of the specific parties and are not traded on regulated exchanges. 

Most often swaps are used to hedge against unfavorable outcomes and are explained more fully in the later discussion of hedging. However, it is important to understand the basic format of a swap. Common examples include foreign currency swaps and interest rate swaps. 

For example, assume a U.S. company has an opportunity to invest in a German joint venture that is expected to last six months.The U.S. company must invest German marks in the venture, and its investment will be returned in German marks at the end of the 6-month period. Through an intermediary, the U.S. company could contract with a German company that needs U.S. dollars for a similar period of time. Each of the companies would have available or borrow their respective currencies and then swap the currencies, dollars for marks and marks for dollars. At the end of the 6-month investment period, the U.S. company would return marks to the German company, and the German company would
return dollars to the U.S. company.

What are the Financial derivatives ?

There are four basic types of derivative instruments as we know. The most important differences are between options and the other three types of derivatives. Futures, forwards, and swaps each provide symmetric risk to a holder because the value of the derivative can change in both directions (gains or losses) without limits. This symmetric risk profile requires both counterparties to execute the contract whether the effect is favorable or unfavorable. In contrast, the holder of an option is not required or obligated to exercise the option and, in fact, will not do so if the option is at- or out-of-the-money. 

This provides asymmetric risk for the holder who may want to avoid downside risk. Options also differ from the other derivative instruments described here in the requirement for an initial cash outlay, which represents the initial intrinsic and time values of the option.

An underlying, a notional amount, and the opportunity for net settlement characterize derivatives.
Major types of derivative instruments include forward contracts, futures contracts, options, and interest rate swaps.
Derivative instruments may be held as an investment and changes in their value should be recognized in current earnings. The value of a derivative is a function of the movement or changes in the underlying and the notional amount.

What is interest rate swap?

An interest rate swap involves exchanging variable (fixed) interest rates for fixed (variable) rates. For example, assume a Company issued $10,000,000 of variable-interest debt when rates were 6% and is now concerned that interest rates will increase. In order to protect against rising rates, the Company contracts with a Bank and agrees to pay a fixed rate of interest of 6.5% to the Bank in exchange for receiving variable rates.

If the variable rate increased to 6.7% on the $10,000,000 of variable interest debt, the Company’s semiannual net interest expense would be determined as follows:

Variable interest paid to creditors (6.7% $10,000,000 1/2 year) . . . . . . . . . . . . $ 335,000
Fixed interest paid to the Bank (6.5% $10,000,000 1/2 year) . . . . . . .. . . ... . . . 325,000*
Variable interest received from the Bank* . . . . . . . . . ... . . . . . . . . . . . . . . . . . . (335,000)
Net interest paid . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... . . . . . . . . . . . . . . . $ 325,000

*Rather than actually paying and receiving, the entities exchange the net difference between the rates (fixed vs. variable) in the amount of $10,000 ($325,000 vs. $335,000). This results in a net interest expense of $325,000 ($335,000 paid to creditors less $10,000 received from the Bank).

The interest swap was entered into because the Company feared that variable rates would increase. In essence, the swap allowed the Company to exchange a variable interest rate for a fixed interest rate as though they had actually issued fixed debt. As the swap continues, new variable rates will be determined and applied to subsequent semiannual interest payments. This process of determining a new rate for the swap is referred to as resetting the rate. Generally, the variable interest rate is reset at each interest date and is applied to the subsequent period’s interest calculations.

 

The valuation of swaps is complex and dependent on assumptions regarding future rates orprices. For example, if a fixed interest payment is swapped for a variable interest payment, the value of the swap is a function of how future variable rates are expected to compare to the fixed rate. Therefore, an estimate of future variable rates is required. Furthermore, the differences between the future variable rates and the fixed rate represent future differences that need to be discounted in order to produce a present value of the differences.

How time value is measured in Options of derivatives?

Option Contracts. An option represents a right, rather than an obligation, to either buy or sell some quantity of a particular underlying. The option is valid for a specified period of time and calls for a specified buy or sell price, referred to as the strike price or exercise price. If an option allows the holder to buy an underlying, it is referred to as a call option. An option that allows the holder to sell an underlying is referred to as a put option. 

Options are actively traded on organized exchanges or may be negotiated on a case-by-case basis between counterparties (over-the-counter contracts). Option contracts require the holder to make an initial nonrefundable cash outlay, known as the premium, as represented by the option’s current value. The current value of an option depends on forward periods and spot prices. The difference between the strike and spot price, at any point in time, measures the intrinsic value of the option, so changes in spot prices will change the intrinsic value of the option. Changes in the length of the remaining forward period will affect the time value of the option. The time value is measured as the difference between an option’s current value and its intrinsic value as in the following.
 

• If the option is in-the-money, the option has intrinsic value. For example, if an investor has an April call (buy) option to buy IBM stock at a strike price of $110 and the current stock price is $112, the option is in-the-money and has an intrinsic value of $2. An option that is out-of the- money or at-the-money has no intrinsic value.

• The difference between the current value of an option and its intrinsic value represents time value. For example, if the IBM April call (buy) option has a current value of $8, the time value component is $6 (the current value of $8, less the intrinsic value of $2). The time value of an option represents a discounting factor and a volatility factor.

• The discounting factor relates to the fact that the strike price does not have to be paid currently, but rather at the time of exercise. Therefore, the holder of an option to buy stock could benefit from an appreciation in stock value without actually having to currently pay out the cash to purchase the stock. For example, assume that a 30-day, at-the-money option has a strike price of $100 and that a discount rate of 12% is appropriate. The ability to use the $100 for 30 days at an assumed discount rate of 12%, rather than having to buy the stock at the current price of $100, is worth $1 ($100 12% 1/12 year). Thus, the ability to have the alternative use of the cash equal to the strike price until exercise date of the option has value.

• The volatility factor relates to the volatility of the underlying relative to the fixed strike price and reflects the potential for gain on the option. Underlyings with more price volatility present greater opportunities for gains if the option is in-the-money. Therefore, higher volatility increases the value of an option. Note that volatility could also lead to an out-of-the-money situation. However, this possibility can be disregarded because, unlike forward or futures contracts, the risk for an option is asymmetric since the holder can avoid unfavorable outcomes by allowing the option to expire.

• The value of an option can be realized either through exercise of the option or through cash settlement. If the option can be exercised any time during the specified period, it is referred to as an American option; if it is exercisable only at the maturity date/expiration of the contract, it is referred to as a European option.

What are distinguishing characteristics of future contracts?

A futures contract is exactly like a forward contract in that it too provides for the receipt or payment of a specified amount of an asset at a specified price with delivery at a specified future point in time. However, the futures contract has the following distinguishing characteristics:

• Unlike forward contracts, futures are traded on organized exchanges. The exchanges help ensure that the trading partners honor their obligations. The exchange clearinghouse actually becomes an intermediary between the buyer and seller of the contract. In essence, the clearinghouse becomes the seller for each buyer and the buyer for each seller.

• The formal regulation of futures contracts results in contracts that are standardized in nature versus customized. For example, the exchange specifies the quantity and quality of commodities traded, as well as the delivery place and date.

• A futures contract requires an initial deposit of funds with the transacting broker. This deposit is referred to as a margin account; it serves as collateral to help ensure that the parties to the contract are able to perform. Each day the contract is valued and marked-to-market. If the contract loses too much value, the holder will have to contribute additional cash to the margin account. If the margin account balance falls below a minimum balance, called the maintenance margin, the investor is required to replenish the account through what is called a margin call.

• Forward contracts represent cash amounts settled only at delivery and therefore represent future amounts that must be discounted to yield a current present value. However, future prices are marked-to-market each day. At the close of each trading day, a new futures price or settlement price is established. Therefore, the futures price represents a current versus future value, and no discounting is necessary. This new futures price is used to compute the gain or loss on the contract over time.

• The party that has written a futures contract is said to be short, and the party that owns the contract is said to be long.

What are the Common Types of Derivatives?

The number of financial instruments that have the characteristics of a derivative has continued to expand, and, in turn, these instruments have become increasingly complex. In spite of the diversity and/or complexity that characterizes them, most derivatives are variations of four basic types, including forwards, futures, options, and swaps. Other more complex derivative instruments are also available.

Forward Contracts. A forward contract is a contract to buy or sell a specified amount of an asset at a specified fixed price with delivery at a specified future point in time. The party that agrees to sell the asset is said to be in a short position, and the party that agrees to buy the asset is said to be in a long position. The specified fixed price in the contract is known as a forward price or forward rate. The current price or rate for the asset is known as the spot rate. The specified future point is referred to as the forward date. Forward contracts are not formally regulated on an organized exchange, and the parties are exposed to a risk that default of the contract could occur. However, the lack of formal regulation means that such contracts can be customized in response to specialized needs regarding notional amounts and forward dates.

The value of a forward contract is zero at inception and typically does not require an initial cash outlay. However, over time, movement in the price or rate of the underlying results in a change in value of the forward contract. The total change in the value of a forward contract is measured as the difference between the forward rate and the spot rate “at the forward date.”

Futures Contracts. A futures contract is exactly like a forward contract in that it too provides for the receipt or payment of a specified amount of an asset at a specified price with delivery at a specified future point in time.

Option Contracts. An option represents a right, rather than an obligation, to either buy or sell some quantity of a particular underlying. Common examples include options to buy or sell stocks, a stock index, an interest rate, foreign currency, oil, metals, and agricultural commodities. The option is valid for a specified period of time and calls for a specified buy or sell price, referred to as the strike price or exercise price. If an option allows the holder to buy an underlying, it is referred to as a call option. An option that allows the holder to sell an underlying is referred to as a put option. Options are actively traded on organized exchanges or may be negotiated on a case-by-case basis between counterparties (over-the-counter contracts). Option contracts require the holder to make an initial nonrefundable cash outlay, known as the premium, as represented by the option’s current value. The premium is paid, in part, because the writer of the option takes more risk than the holder of the option. The holder can allow the option to expire, while the writer must comply if the holder chooses to exercise it.

Swaps. A swap is a type of forward contract represented by a contractual obligation, arranged by an intermediary that requires the exchange of cash flows between two parties. Swaps are customized to meet the needs of the specific parties and are not traded on regulated exchanges. Most often swaps are used to hedge against unfavorable outcomes. However, it is important to understand the basic format of a swap. Common examples include foreign currency swaps and interest rate swaps.

What are the characteristics of derivative intstruments?

A critical characteristic of a derivative and the basis for its name is that the instrument derives its value from changes in the value of a related asset or liability. The rates or prices that relate to the asset or liability underlying the derivative are referred to as underlyings. The underlying may take a variety of forms, including a commodity price, stock price, foreign currency exchange rate, or interest rate. It is important to note that the underlying is not the asset or liability itself, but rather its price or rate. For example, the underlying in an option to buy a share of stock at a fixed price of $50 is not the stock itself; it is the $50 price of the stock, and it determines the value of the derivative. 

Changes in the underlying price or rate cause the value of the derivative to change. For example, if the price of a stock underlies the value of an option to buy that stock, changes inthe price of the stock relative to the option price will cause the value of the option to change. If the underlying price of the stock changes from $50 to $52, then the option to buy at $50 has increased in value by $2 (one could buy the stock for $50 when it has a fair value of $52).

In order to fully value a derivative, one must know the number of units (quantity) that is specified in the derivative instrument. This is called the notional amount, and it determines the total dollar value of a derivative, traceable to movement or changes in the underlying. For example, if the option to buy stock for $50 increases in value because the underlying price of the stock moves from $50 to $52, the total magnitude of this increase in value depends on how many shares can be purchased under the terms of the option. If the option applies to 1,000 shares, then the total value of the option is $2,000 (a $2 change in the underlying price of $50 to $52 times a notional amount of 1,000 shares). The notional amount of a derivative might refer to so many bushels of a commodity, number of shares, foreign currency units, or principal amount of debt. Both the underlying price or rate and the notional amount are necessary in order to determine the total value of a derivative at any point in time.

Typically, a derivative requires little or no initial investment because it is an investment in a change in value traceable to an underlying, rather than an investment in the actual asset or liability to which the underlying relates. For example, if the price of a stock increases, the value of an option to buy that stock also increases. If one actually owned the stock, an increase in the price of the stock would also result in increased value. However, the important difference is that in order to experience the increase in value an option holder needs to make little or no initial investment, whereas the owner of the stock has to make a significant investment to acquire the stock in the first place.

Many derivatives do not require the parties to the contract, the counterparties, to actually deliver an asset that is associated with the underlying in order to realize the value of a derivative. For example, the option to buy a share of stock at a fixed price would allow the holder to sell the option rather than requiring the other counterparty to actually transfer stock to them at the option price. Assume that a stock is trading at $52 per share and that one holds an option to buy stock at $50 per share. The holder could sell the option for $2 or require the counterparty to sell them stock at $50. If the stock were purchased for $50, it could readily be converted into cash by selling at $52, thereby realizing a gain of $2. 

The ability to settle the contract in exchange for cash, without actually buying or selling the related asset or liability, is referred to as net settlement. A derivative may be a separate, distinct financial instrument, or it may be embedded in another financial instrument. An embedded derivative has economic characteristics and risks that are not clearly and closely related to those of the host instrument. For example, a convertible bond is a host contract that also contains an embedded derivative. That derivative represents the option to convert the bond into common stock; its underlying is the price of the respective stock. The conversion feature’s economic value is more closely related to the underlying stock than the bond. If the embedded derivative meets certain criteria, it should be separated, or bifurcated, from the host contract and be accounted for as a separate instrument.