Question 2 (25 marks)

Most firms hedge at least some of their risks. Hedging can take two basic forms—namely, natural hedging and hedging by means of derivative instruments. The use of derivatives as hedges has expanded greatly in recent years.

Generally, under accounting standards (IAS 39 and related U.S. standards), derivative instruments are fair-valued with any unrealized gain or loss included in net income. However, hedge accounting provides some exceptions to this rule.

Required:

1. A firm has a large amount of long-term debt (valued on a cost basis) and decides to set up a natural hedge of this debt. However, a natural hedge can lead to excess net income volatility—that is, net income volatility greater than the actual volatility of the firm’s operations. Explain how this can happen.

   (5 marks)

2. Suggest two ways that the excess net income volatility arising in part (a) can be prevented. (6 marks)
3. IAS 39 identifies two basic types of hedge. Describe each type. For each type, explain how IAS 39 controls excess net income volatility arising from entering into the hedge.(8 marks)
4. Use the bonus plan hypothesis of positive accounting theory to explain why a firm manager dislikes excess net income volatility. Are the policies to control excess net income volatility you described in parts (a) and (b) unethical? Explain why or why not.(6 marks)

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