Question

P14-7. Nature and identification of financial instruments L.O. 14-1) (Medium - 10 minutes) Identify the examples of derivatives that follow as one of the following: Forward contract Future contract Option Warrant Swap a Canadian Inc. (which has some US operations) contracts with American Corp. (which has some Canadian operations) to pay the interest and principal on a US$20,000,000 loan in exchange for American Corp making the payments on a Canadian dollar loan of equal value. b. Marianne Corp contracts with its bank to sell them US$100,000 cash in December 2018 at a rate of C$1.15/US$1.00 c. An investor purchases a bundle of securities that includes a $1,000 bond issued by Starlight Inc. and the right, but not the obligation, to purchase 20 common (ordinary) shares in the company for $38 each in three to five years' time.

Answer 1

a. This transaction represents a "Swap". Swap is basically entered between 2 organizations when the interest rate desired by one entity is available with the other entity and vice-versa in which case they enter into a swap agreement to meet each other obligations at the rates desired by each one of them.

b. This transaction represents a "Forward Contract". Here Marianne Corps is basically entering into a forward contract with the bank to sell them currency in December 2018 at the forward rate of C$ 1.15/US $1.00. A forward contract is a binding contract and the failure to meet such contract will impose penalty charges on the non-compliant party.

c. This transaction represents an "Option". To be precise, this transaction represents a "Call Option" which is an option to buy the shares at a later date if it suits the investor. It is not necessary for the investor to purchase the shares. He will purchase them if the price of such shares increase above 38 $ in which case he would be in a profit.