12 Fischer10e SM Module Final

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DERIVATIVES MODULE
UNDERSTANDING THE ISSUES
1. The intrinsic value of a forward contract to

reases $700, then the time value has
ed
ue inc
sell a commodity or currency is determined

by $200. This $200 change
decreas
by comparing the spot rate/price at the date

be recognized in current income.
would
of inception of the forward to the spot

in the intrinsic value over time are
Changes
rate/price at a later valuation date. At date

lly recorded as a component of other
initia
of inception of the forward, the difference

ensive income and therefore do
between
the
forward
currently
impact
operating
rate
and
income.
spot
represent the total time value of the conr, these amounts will affect current
compreh
not
Howeve
tract. Both the intrinsic value and time value

ng income when the hedged item it-
operati
per item must be multiplied by the notional

ffects current operating income. For
self a
amount in order to calculate the respective

, if the above option hedged a fo-
example
total values.
ed sale of inventory, changes in the
recast
intrin
sic value would not be recognized curA put option has intrinsic value only if the
rently
until the hedged sale affected current
strike price one can sell at is greater than
.
income
the current spot price. The difference between these two values times the notional
a futures contract, an option contract
amount represents the total intrinsic value.
ents a right, rather than an obligaThe time value of an option is measured by
hile the option contract requires the
subtracting the intrinsic value from the total
make an initial nonrefundable
4.
Unlike
repres
tion. W
holder
to
value of the option.

tlay, the holder can allow the option
cash ou
to exp
ire in unfavorable conditions. In the

2. A firm commitment to sell inventory is fixed
case o
f a futures contract, the contract
in terms of the quantity, price, and delivery
be exercised even if on unfavorable
must
terms. Therefore, if the price of the inventoterms.

ry changes prior to execution of the commitment, the commitment may
rest rate swap involves exchanging
become
more or less valuable than anticipated.

interest rates for fixed interest
Keeping in mind that the price is fixed, a

or fixed interest rates for variable in-
5. An inte
variabl
rates
commitment to sell will become less valuarates. For example, assume that a
terest
ble if prices increase prior to execution of

has borrowed $3 million at a vari-
company
the commitment. This exposure to loss may

terest rate of LIBOR plus 2% points.
able in
be effectively hedged against through the

ed that interest rates will increase,
Concern
use of a derivative instrument such as a

rower could agree to pay a counter-
the bor
contract or option to buy inventory. In a

a fixed rate of interest in exchange for
party
highly effective hedge, the loss in value on

ing a variable rate of interest which
receiv
the firm commitment should be offset by

e paid to the original lender. For ex-
will b
the gains in value on the derivative instruassume the borrower agrees to pay
ample,
ment.
xed in exchange for receipt of a va-
6.5% fi
riable
rate of LIBOR plus 2%. If LIBOR is

3. A cash flow hedge of a forecasted transacgreater
than 4.5%, the borrower will gain
tion affects both current and future operatfrom t
he swap and effectively reduce their
ing income. The effect on current operating
intere
st expense to a fixed rate of 6.5%.
income is represented by the change in
Howeve
r, if LIBOR is less than 4.5%, the
time value of the hedging instrument. This
borrow
er will be paying more than the variis measured as the change in total value
able i
nterest rate in that they have fixed
over time less the change in intrinsic value
nterest rate at 6.5%.
their i
over time. For example, if an options total

value increases $500 and the intrinsic val-
475
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Derivatives ModuleExercises
EXERCISES
EXERCISE 1
Because the option hedges a forecasted transaction, the only impact on earnings
prior to the
transaction actually taking place and then, in turn, affecting earnings itself w
ill be changes in the
time value of the option.
The impact on earnings for the first and second 30-day period is a charge agains
t earnings of
$2,000 and $2,500, respectively, to be recognized as an unrealized loss on the h
edge.
30 Days
Expiration
Beginning
Later
Date
Notional amount in tons .............................

500
500
500
Strike price .................................................

$1,200
$1,200
$1,200
Spot rate ....................................................

$1,214
$1,216
$1,201
Intrinsic value (if spot is > strike) ................

$7,000
$8,000
Time value .................................................

$2,500
Total value .................................................

$9,500
$8,000
500
$4,500
$5,000
Regarding the hedge against a fixed rate loan, the impact on earnings would be t
he fixed interest expense as adjusted for the settlement of rate differences determined as fol
lows:
First
30 Days
Next
30 Days
Fixed interest ($3 million 8% 1/12 year) .....................

$20,000
$20,000
Settlement of rate differences:
(8.1% vs. 8% on $3 million 1/12 year) .....................
250
(7.8% vs. 8% on $3 million 1/12 year) .....................
(500)
Net interest expense .........................................................
$20,250
$19,500
Gain on swap (increasing basis of swap asset) ................
(3,000)
(300)
Loss on swap (increasing the basis of the liability) ...........
3,000
300
Total charge against earnings ...........................................
$20,250
$19,500
476
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EXERCISE 2
Corn Futures
June 1
June 30
July 31
Number of bushels .....................................

150,000
150,000
150,000
Spot price/bushel ....................................... $

$
3.41
$
3.43
3.42
Future price/bushel .................................... $

$
3.53
$
3.54
3.56
Fair value of contract:

(original futures price vs. current
futures price notional amount) ..........
$ 4,500
$
3,000
Current-period gain (loss) in:
Value of contract ..................................
4,500
(1,500)
Intrinsic value (change in spot rates) ...

1,500
(1,500)
(Note
A)
Time value (spot-forward difference)

or change in contract value less
change in intrinsic value .................
3,000
Note A: Because the July 31 spot rate is greater than the June 30 spot rate, th
e contract has no in-
trinsic value. Therefore, the value of the contract must be traceable to time va
lue.
As a result of the above hedging activity, the following changes would occur:
June
July
Increase (decrease) in value of inventory ....

(1,500)
$ 1,500
Gain (loss) on futures contract:

Intrinsic value component .......................
$ 1,500
$
(1,500)
Time value component ...........................
3,000
...
Total ....................................................
$ 4,500
$
(1,500)
477
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Exercise 2, Concluded
Wheat Futures
June 1
June 30
July 31
Number of bushels .....................................

150,000
150,000
150,000
Spot price/bushel .......................................

$
6.19
$ 6.175
6.20
Future price/bushel ....................................

$
6.33
$
6.32
6.35

$ 3,000
$ 4,500
3,000
1,500

1,500
2,250

1,500
(750)
As a result of the above hedging activity, the following changes would occur:
June
July
Increase (decrease) in value of inventory ....

$ (1,500)
$ (2,250)
Gain (loss) on futures contract:
1,500
Intrinsic value component .......................

$
2,250
1,500
Time value component ...........................

(750)
3,000
Total .....................................................
$
1,500
..
EXERCISE 3
20X3
June 30
(1)
December 31
Net interest expense:

Fixed interest (9% $4,000,000 year) ............
180,000
$
180,000
Settlement of rate difference:

(8.75% vs. 9% on $4,000,000 year) ..........
(5,000)
(8.50% vs. 9% on $4,000,000 year) ..........
(10,000)
$
(2)
..
Net interest expense ...............................................

175,000
$
170,000
Carrying value of note payable:

Original face value ................................................
$4,000,000
$4,000,000
Change in value of debt ..........................................
14,000
3,500
Carrying value of debt .............................................

$4,014,000
$4,003,500
(3)
Net unrealized gain (loss) on the swap ........................

$
0
$
0
478
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EXERCISE 4
(1) Critical criteria that must be satisfied in order to justify classificatio

n as a fair value hedge
include the following:
a.
At inception, the hedging relationship is identified and documented.
b. There is an expectation that the hedge will be highly effec

tive. Effectiveness of the
hedge must be assessed at inception and on an ongoing basis.
c. The hedged item is a firm commitment that is exposed to ch
anges in value as commodity prices change that could affect earnings.
d. The hedge item (the commitment) is not being measured at fai
r value to reflect both
positive and negative changes in value (commitments that are not hedg
ed are generally
only adjusted to reflect downward changes in value).
(2) Several factors that could suggest that the hedge is highly effective incl
ude the following:
a. The option is for the same notional amount (100,000 bushels) as is th

e commitment.
b. The delivery location for the option is not significantly different t
han the location for the
actual commitment.
c. Changes in corn price for delivery in a different location than the c
ommitment correlate
highly with changes in prices at the actual delivery location.
d.
The term of the option corresponds with the term of the commitment.
(3) An option may provide more flexibility than a futures contract because an
option does not
have to be exercised if it is out-of-the-money, unlike a future. Therefor
e, if corn prices increase above the strike price of $1.51 a bushel, the company is not obliga
ted under the option to sell at the strike price. The only cost incurred by the company in
that case is the initial cost of the option.
(4) The value of an option consists of two components: intrinsic value and tim
e value. The former represents the extent to which the current spot price compares favorab
ly to the strike
price. In the case of a put option, if the current price is less than the
strike price, then the
option has intrinsic value. The time value of an option reflects a variety
of factors including
the time until expiration and potential price volatility. Therefore, even
if there is no intrinsic
value currently, there may be time value in that things could change so th
at the option ultimately has intrinsic value. Obviously, at the expiration date, no
time value is associated
with an option.
(5) Granted, with an option you are either in-the-money or you are not. Theref
ore, an option
may not have a negative value. However, at inception, one must pay for the
option, and this
cost is incurred regardless of subsequent developments affecting the value
of the option.
One can certainly lose money on an option to the extent of this initial co
st.
(6) The initial time value component of an options value is allocated to earnin
gs over the period of the term of the option. The amount of time value allocated to each
period is determined by measuring changes over time in the time value of the option. The
time value of
the option at any point in time is determined by subtracting from the valu
e of the option the
intrinsic component of value leaving the time value component.
479
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EXERCISE 5
(1)
Analysis of changes in the value of the put option:
April 1
April 30
May 31
Notional amount in tons ...................
June 15
1,0
00
1,000
1,000
1,000
Strike price .......................................

$
700
$
700
$
700
Spot price.........................................
696
697
Intrinsic value (if strike is > spot) .....
4,000
3,000
00
Time value .......................................

300
500
00
Total value .......................................

4,300
3,500
700
701
695
5,000
1,0
1,0
5,000
Apr.
1 Investment in Option .....................................
.......................
1,000
Cash ................................................
.................................
1,000
To record payment of option premium.
30 Loss on Commitment .......................................

....................
4,000
.......................
Firm Commitment .....................................

4,000
To record change in fair value of commitment
[($696 $700) 1,000].
Investment in Option .....................................

.......................
4,000
Unrealized Gain on Option ...........................
4,000
....................
To record change in intrinsic value of option.
...................
Unrealized Loss on Option ................................

700
........................
Investment in Option ................................

700
To record change in time value of option
($1,000 on April 1 vs. $300 on April 30).
May 31
Firm Commitment ..........................................
.......................
1,000
Gain on Commitment ..................................
1,000
.....................

[($697 $696) 1,000].
...................
Unrealized Loss on Option ................................

1,000
1,000
........................
Investment in Option .....................................

.......................
200
....................

200
($300 on April 30 vs. $500 on May 31).
480
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June 15
Loss on Commitment ......................................
.....................
2,000
Firm Commitment .....................................

2,000
.......................

[($695 $697) 1,000].
Investment in Option ....................................

........................
2,000
2,000
....................
....................
Unrealized Loss on Option ...............................

500
........................

500
($500 on May 31 vs. $0 on June 15).
Cash ....................................................
.................................
5,000
........................

5,000
To record net settlement of option.
Inventory of Cocoa ......................................

.........................
695,000
Firm Commitment .........................................
........................
5,000
Cash ................................................
.................................
700,000
To record purchase of cocoa at $700 per ton.
Instructor s note: The net effect on earnings of the fair value hedge is
as follows:
Without the
With the
Hedge
Hedge
Assumed sales value .....................................................

...........
$
800,000 $
800,000
Cost of cocoa sold ......................................................
..............
(700,000)
(695,000)
Assumed gross profit ....................................................
............
$
100,000 $
105,000
Gain (loss) on commitment ...............................................
........
(5,000)
Gain (loss) on option ...................................................
..............
5,000
..
Gain (loss) excluded from effectiveness .................................

(1,000)
Net effect on earnings ..................................................

.............
$
100,000 $
104,000
(2) If the strike price had been $698 per ton, the hedge would not have been t
otally effective.
The commitment would have still lost $5,000 and the option s in
trinsic value would have
gained only $3,000 [($698 $695) 1,000].
481
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EXERCISE 6
(1)
Analysis of changes in the value of the call option:
February 28
February 20
April 20
March 31
Notional amount in pounds ........

300,000
300,000
300,000
300,000
Strike price .................................

$
1.60
$
1.60
$
1.60
Spot price...................................
1.59
1.62
1.64
1.60
1.61
Intrinsic value (if strike

is < spot) .............................
6,000
Time value .................................
1,200
800
Total value. ................................
1,200
6,800
3,000
12,000
800
500
3,800
12,500
Feb. 20
........................
3,800
Cash ................................................
.................................
3,800
To record payment of option premium.
28
...............
Other Comprehensive Income...............................

3,000
........................

3,000

........................
400
....................

400
($800 on February 20 vs. $1,200 on February 28).
Mar. 31
........................
6,000
Other Comprehensive Income ..........................
6,000
...............
....................

400
........................

400
($1,200 on February 28 vs. $800 on March 31).
Apr. 20
........................
6,000
Other Comprehensive Income ..........................
6,000
...............
....................

300
........................

300
($800 on March 31 vs. $500 on April 20).
Cash ....................................................
.................................
12,500
........................

12,500
482
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May
3
...................
Inventory of Soybean Meal ................................

489,000
Cash .................................................
................................
489,000
To record purchase at $1.63 per pound.
During
May
Inventory of Food ........................................
.........................
489,000
Inventory of Soybean Meal ............................
489,000
..................
To record use of meal to make food.
June
Cost of Sales ............................................
............................
240,000
..............
Other Comprehensive Income................................

4,500
.........................
Inventory of Food ....................................

244,500
To record sale of one-half of the food and the
reclassification of other comprehensive income.
(2) The net effect on earnings with and without the cash flow hedge is as foll
ows:
Without the
Hedge
With the
Hedge
Assumed sales value .....................................................

...........
$
300,000 $
300,000
Cost of sales ...........................................................
..................
(244,500)
(240,
0
Assumed gross profit ....................................................
............
$
55,500 $
60,000
Gain (loss) excluded from effectiveness .................................
(300)
..
Net effect on earnings. .................................................

............
$
55,500 $
59,700
If the forecasted purchase had not been hedged, there would hav
e been a $4,200 decrease in earnings.
483
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EXERCISE 7
(b)
(1)
(a)
Interest
(c)
Loan Balance
Interest at
Received from
Original
Counterparty
Inte
rest Paid to
at Beginning of
Co
unterparty
Quarter
Rate (4.5%)
Amount
at Rate (4.2%)
Rate
Quarter 1 ...................................
00* $1,350,000
$1,260,000
$1,275,000
$120,000,0
4.25%
000
Quarter 2 ...................................
1,307,813
1,220,625
1,264,219
116,250,
4.35
000
Quarter 3 ...................................
1,265,625
1,181,250
1,082,813
112,500,
3.85
000
Quarter 4 ...................................
1,223,438
1,141,875
992,344
108,750,
3.65
$5,146,876
$4,614,376
$4,803,750
*$150,000 ($3,750,000 8 quarters) = $120,000,000.
(2)
(b)
Interest
Received from
Counterparty
(c)
at Rate (4.2%)
Net Payment
(a)
Loan Balance
Interest Paid to
at Beginning of
Counterparty
Rate
Quarter
Amount
Quarter 1 ...................................
00* $1,102,500
3.55%
$170,625
$105,000,0
$
931,875
000
Quarter 2 ...................................
1,063,125
3.55
164,531
898,594
,000
Quarter 3 ...................................
1,023,750
3.55
158,438
865,313
,000
Quarter 4 ...................................
984,375
3.55
152,344
832,031
$4,173,750
$645,938
101,250,
97,500
93,750
$3,527,813
*$150,000 ($3,750,000 12 quarters) = $105,000,000.
(3) Using the LIBOR rate of 3.55%, the net present value of the net payments a
t the beginning of the second year of the swap is
$632,120 [the net present value of the four net payments ($170,625; $164,5
31; $158,438; $152,344) discounted at 3.55%/4].
(4) As the floating rate decreases relative to the receive fixed rate, the val
ue of the swap increases. If the spread between the receive fixed and pay floating begins to decrease, the value of the swap wil
l decrease. The value of the swap is also influenced by
the amount of time remaining on the swap. In essence, the value of the swa
p reflects the present value of the anticipated net
payment over the remaining term of the swap.
484
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Derivatives ModuleProblems
PROBLEMS
PROBLEM M-1
(1) The use of derivatives for speculative purposes is prohibited. Derivatives

are used to manage market risk from changes in foreign exchange rates, commodity prices,
compensation
liabilities, and interest rates.
(2) The hedging activity that has an impact on other comprehensive income is t
hat which is
associated with cash flow hedges. Some of the hedges are used with respect
to the variability in future cash flows attributable to changes in foreign c
urrency exchange rates or
commodity price changes. In addition, the company uses interest rate swaps
and treasury
lock agreements as cash flow hedges.
(3) A cash flow hedge is used to establish fixed prices or rates when future c
ash flows could
vary due to changes in prices or rates. The interest rate swaps that are u
sed as cash flow
hedges are designed to hedge against the adverse effects of variability in
cash flows associated with existing debt that has variable interest rates or with forecas
ted transactions, as
is the case with the treasury lock agreements related to the anticipated f
ixed rate note issuance to finance the acquisition of York. A fair value hedge is used to o
ffset changes in
the fair value of items with fixed prices or rates. The interest rate swap
s that qualify as fair
value hedges are not hedging against variability in cash flows but rather
hedging against
changes in the value of fixed rate debt. The company hedged both its fixed
rate 5% notes
maturing in November 2006 and its 6.3% notes maturing in February 2008. In
both cases,
the company received a fixed dollar rate of interest and paid interest bas
ed on a floating
rate of LIBOR plus basis points.
(4) The hedge of the 6.3% notes requires the company to pay a fixed rate of 6.
3%. Anticipating
that variable or floating rates would result in lower interest expense, th
e company agreed to
pay to a counterparty a floating rate of LIBOR plus 283.5 basis points in
exchange for a
fixed rate of 6.3%. The rate is reset every three months. Regarding the im
pact on earnings,
the gain or loss on the swap would be recorded as a change in the value of
the swap and
an offsetting gain or loss would be recorded as an adjustment t
o the basis of the debt.
Therefore, the net effect would be zero. However, the fixed interest expen
se on the debt
would be adjusted (increased or decreased) to reflect the settlement of in
terest rate differences. If the floating rate paid were less than the fixed rate received, t
he company would
experience a decrease in interest expense.
485
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PROBLEM M-2
(1)
September 30
Corn Futures
October 31
September 1
November 5
Number of bushels. ........................

1,000,000
1,000,000
1,000,000
$
$
1,000,000
Spot price per bushel ......................

$2.5380
$2.5680
$2.5685
$2.5000
Futures price per bushel .................

$2.5420
$2.5700
$2.5100
$2.5710
Fair value of contract ...................

32,000
$
60,000
$
61,000
(a) Change in above fair value ....

32,000
$
28,000
1,000
(b) Change in spot rates:

$2,500,000
2,538,000
$
At beginning of period .......

$2,538,000
$2,568,000
At end of period ................
2,568,000
2,568,500
Change ..................................
38,000
$
30,000
$
500
(a) (b) = Change in spot-forward

$
difference ...............................
(6,000)
$
(2,000)
September 30
Wheat Futures
October 31
500
September 1
November 5
Number of bushels. ........................

2,000,000
2,000,000
2,000,000
2,000,000
Spot price per bushel ......................

$3.5480
$3.5700
$3.5700
$3.5150
Futures price per bushel .................

$3.5520
$3.5710
$3.5210
$3.5705
Fair value of contract ...................

62,000
$
100,000
$
$
$
(a) Change in above fair value ....

62,000
$
38,000
$
99,000
(1,000)
(b) Change in spot rates:

At beginning of period .......
$7,096,000
$7,140,000
$7,030,000
At end of period ................

7,140,000
7,140,000
7,096,000
$
Change ..................................
66,000
$
44,000
$
(a) (b) = Change in spot-forward

$
difference ...............................
(4,000)
$
(6,000)
(1,00
0)
Sept. 1
Memo entry to record the acquisition of the futures contra
ct.
Margin Account ...........................................

.........................
70,000
Cash .................................................
................................
70,000
To record margin account deposit.
30
.................
Futures ContractCorn ......................................

32,000
................
Futures ContractWheat .....................................

62,000
...................
Unrealized Hedging Loss ..................................

10,000
..............
Other Comprehensive Income ...........................

104,000
To record change in value of contract and
include in earnings change in time value
excluded from hedge effectiveness.
486
----------------------- Page 13-----------------------
Problem M-2, Concluded
Oct. 31
................
Futures ContractCorn .......................................

28,000
...............
Futures ContractWheat ......................................

38,000
..................
Unrealized Hedging Loss ...................................

8,000
..............

74,000
Nov.
5
................
Futures ContractCorn .......................................

1,000
..................
Unrealized Hedging Loss ...................................

500
...............
Futures ContractWheat .................................

1,000
..............

500
Cash .....................................................
..........................
230,000
.................
Futures ContractCorn ..................................

61,000
...............
Futures ContractWheat .................................

99,000
.........................
Margin Account .......................................

70,000
To record settlement of futures and return
of margin account.
21
.............
Other Comprehensive Income.................................

178,500
...................
Cost of SalesCorn .....................................

68,500
..................
Cost of SalesWheat ....................................

110,000
To adjust cost of sales for the recognition
of gains on futures contracts.
(2) Factors that might cause the futures contracts to not be highly effective
include the following:
a. Changes in the price of wheat and corn may not correlate as highly w
ith the change in
the price of flour due to costs associated with producing flour.
b. The CBT prices reflect delivery of commodities at a location that is

different than the
location of commodities used to make flour that is used by CBBI.
c. The quality of the commodities traded on the CBT may be different th

an the quality of
the commodities used to make the flour acquired by CBBI.
d. The quantity of flour used by CBBI and therefore the equiv

alent amount of corn and
wheat may be greater than the notional amount of the futur
es contracts. Therefore,
some of the cash flows would not be hedged.
487
----------------------- Page 14-----------------------
PROBLEM M-3
September Futures Contract
June 15
June 30
September
Number of gallons ......................................

420,000
420,000
420,000
Spot price per gallon ..................................

$
2.075
$
2.12
Future price per gallon ...............................
$
2.08

8,400
$

$
$
2.09
2.10
8,400
(8,400)

6,300
(6,300)
(Note
A)

2,100
(2,100)
Note A: The contract expires in September; at that time, the spot/future rate i
s greater than the
contracted future rate. Therefore, the contract has no value at its expiration d
ate.
As a result of the above hedging activity, the following account balances would
result:
2nd
3rd
Quarter
Quarter
Income statement accounts:
Gain (loss) on inventory change ...................
$
6,300
(6,300)
Gain (loss) on futures due to:
6,300
Change in intrinsic value ........................

$
(6,300)
2,100
Change in time value ..............................

(2,100)
Total income statement values .....................

$
(2,100)
2,100
Balance sheet asset accounts:

Increase (decrease) in inventory ..................
$
6,300
(6,300)
8,400
Increase (decrease) in futures contract ........

(8,400)
488
----------------------- Page 15-----------------------
October Futures Contract
Wheat Futures
June 15
June 30
July 31
Number of bushels .............................
630,000
630,000
630,000
Spot price per bushel ......................... $

46
$ 2.169
2.12
2.1
Future price per bushel ...................... $

18
$
2.20
2.15
2.

futures price notional amount) ..

$ 31,500
$ 18,900

Value of contract ..........................
12,600
18,900
Intrinsic value (change in spot

14,490
16,380
rates) ..................................................

or change in contract value
less
0
change in intrinsic value .........

(1,890)
2,52
As a result of the above hedging activity, the

following account balances would result:
2nd
3rd
Quarter
Quarter
Income statement accounts:
3,104)
Gain (loss) on inventory change ..........

(11,592)
(Note
B)
(3,276)
Gain (loss) on firm commitment ..........

(2,898)
(Note
(1
C)
Gain (loss) on futures due to:
Change in intrinsic value ...............
14,490
(Note
16,380
D)
Change in time value .....................
(1,890)
(Note
2,520
D)
Total income statement values ............
(1,890)
2,520
(1
Balance sheet asset accounts:
3,104)
Increase (decrease) in inventory .........

(11,592)
(Note
B)
(3,276)
Increase (decrease) in firm commit(2,898)

(Note
ment
C)
Increase (decrease) in futures con12,600
18,900
tract
Note B: This represents the impact of the hedge on existing inventory (12/15 of
the change in
intrinsic value).
Note C: This represents the impact of the hedge on the firm sales commitment (3
/15 of the
change in intrinsic value).
Note D: This represents the change in value traceable to both hedges.
489
----------------------- Page 16-----------------------
490
----------------------- Page 17-----------------------
PR
OBLEM M-4
(1)
nterest
I
Date
Amount
Payment
Quarterly Rate
Principal
Balance
December 31, 20X7 .......

$12,590,619
March 31, 20X8 .............
$157,383
$ 979,025
$1,136,408
11,611,594
June 30, 20X8................

145,145
991,263
1,136,408
10,620,331
1.25%
1.25
September 30, 20X8 ......

132,754
1,003,654
1,136,408
9,616,677
1.25
December 31, 20X8 .......

120,208
1,016,200
1,136,408
8,600,477
1.25
Totals ........................
$555,490
$3,990,142
$4,545,632
(2)
nterest
I
Date
Amount
Payment
Quarterly Rate
Principal
Balance
June 30, 20X8................

$10,000,000
$115,000
$
December 31, 20X8 .......

108,750
Totals ........................
$223,750
$
(3)
$115,000
1.1500%
10,000,000
108,750
10,000,000
1.0875
$223,750
Balance at
Receive
t Interest
Date
Fixed Rate
Beginning
Stated Interest
Net Swap
of Quarter
Pay
Ne
Floating Rate
Interest
on Note
Expense
March 31, 20X8 .............
1.1875%
$
7,383
$12,590,619
1.1875%
$157,383
June 30, 20X8................

1.1875(2,903)
145,145
11,611,594

1.1875(9,293)
132,754
10,620,331
December 31, 20X8 .......

1.1875
(14,425)
05,783
$15
1.1625
142,242
1.1000
123,461
9,616,677
Totals ........................
$(26,621)
1.0375
120,208
$555,490
528,869
(4)
Balance at
Receive
t Interest
Date
Fixed Rate
Income
Net Swap
Beginning
Stated Interest
of Quarter
Interest
Pay
Floating Rate
Ne
on Note*

1.1250%
$(2,500)
120,000
December 31, 20X8 .......
1.1250 3,750
20,000
$10,000,000
1.1500%
$122,500
10,000,000
Totals ........................
$ 1,250
1.0875
116,250
$238,750
240,000
*$10,000,000 x (2.90% + 2.0%)/4 = $122,500; $10,000,000 x (2.65% + 2.0%)/4 = $11

6,250.
491
----------------------- Page 18-----------------------
(5)
.
Pay floating rate interest per quarter ($10,000,000 1.0875%) .............

$108,750
Receive fixed rate interest per quarter ($10,000,000 1.1250%) ...........
112,500
Difference per quarter ..................................................

............................
$
3,750
Number of quarters remaining ............................................

.....................
4
Net present value of difference = 4 quarters, i = 1.0875% ...............

$ 14,601
.......
(6) In addition to the risk that the interest income on the note would decline
due to falling variable interest rates, there is now a concern due to changing currency exchange rates. If the interest income is t
o be received in euros and the euros are exchanged into dollars, it is possible that the number of dollars received could decl
ine over time. This would be the case if the euro weakened
relative to the dollar.
492
----------------------- Page 19-----------------------
PROBLEM M-5
July 10
July 31
August 31
Notional amount in troy ounces. ..........

100,000
100,000
Sept. 10
100,000
100,000
Strike price ...........................................

$5.00
$5.00
$5.00
$5.00
Spot price .............................................

$5.14
$5.35
$5.32
$5.10
Intrinsic value (if strike is < spot) ..........

$14,000
$35,000
$10,000
$32,000
Time value ...........................................

$9,000
$2,000
$1,000
$10,000
Total value ...........................................

$23,000
$37,000
$33,000
$20,000
July
10
...............
Investment in Call Option ...................................

20,000
Cash ..................................................
..........................
20,000
To record payment of option premium
(100,000 $0.20).
31
...............

3,000
Unrealized Loss on Hedge ($10,000 $9,000) .................
1,000
Other Comprehensive Income ($10,000 $14,000) ...
4,000
To record change in value of the option. The
change in time value is excluded from assessment
of hedge effectiveness.
Aug.
31
...............

14,000
............
Unrealized Loss on Hedge ....................................

7,000
.........
Other Comprehensive Income ............................

21,000
To record change in value of option.
Sept. 10
.............
........
...............
Unrealized Loss on Hedge ...................................

1,000
Other Comprehensive Income ..................................
3,000
Investment in Call Option .............................
4,000
To record change in value of the option.
Cash ......................................................
.........................
33,000
...............
Investment in Call Option .............................

33,000
15
Inventory of Silver .........................................
.....................
533,000
............
Accounts Payable (or Cash) ............................

533,000
To record purchase of inventory (100,000 $5.33).
Sept.
.................
..................
Accounts Receivable ........................................

225,000
Plating Revenues ......................................
225,000
To record sales.
Cost of Sales ...............................................

......................
184,950
...............
Other Inventoriable Costs .............................

105,000
........
Inventory of Silver (15,000 $5.33) ....................

79,950
To recognize cost of sales.
493
----------------------- Page 20-----------------------
Sept.
.........
Other Comprehensive Income .................................

3,300
.......................
Cost of Sales ........................................

3,300
To adjust cost of sales [(15,000 divided by
100,000) $22,000 of OCI].
Oct.
.................
Accounts Receivable ........................................

750,000
Plating Revenues .....................................
750,000
...................
To record sales.
Cost of Sales ..............................................

.......................
616,500
................
Other Inventoriable Costs ............................

350,000
.........
Inventory of Silver (50,000 $5.33) ...................

266,500
To recognize cost of sales.
Other Comprehensive Income .................................

11,000
.........
.......................
Cost of Sales ........................................

11,000
To adjust cost of sales [(50,000 divided by
100,000) $22,000 of OCI].
PROBLEM M-6
July
a.
August
September
Total
Call Option A
Unrealized gain (loss) on commitment:
10,000 ($45 $46) .................................................
$(10,000)
$(10,000)
10,000 ($45 $44) .................................................

$
10,000
10,000
10,000 ($45 $46.50) ............................................
$( 15,000)
(15,000)
Less: Previously recognized gain (loss) ....................
10,000
(10,000) .................................................................
...........
Net unrealized gain (loss)..........................................
$(10,000)
$
20,000
$(25,000)
Unrealized gain (loss) on hedge ...................................
10,000
(10,000)
15,000
15,000
Change in time value excluded from effectiveness:
Time value of $2,000 at beg. vs. $2,400 at end ........
400
Time value of $2,400 at beg. vs . $1,000 at end ........
(1,400)
400
(1,400)
Time value of $1,000 at beg. vs. $1,000 at end ........

Net gain (loss) ..........................................................
......... $
400
$
8,600
$(10,000)
$
(1,000)
b.
Call Option B (hedge not effectivedoes not qualify for special hedge accoun
ting)
Unrealized gain (loss) on option:
....
($900 $1, 100) .....................................................

(200)
$
(200)
....
($600 $900) ........................................................

$
(300)
(300)
....
($200 $600) ........................................................

$
(400)
(400)
........
Net gain (loss) .......................................................

$
(200)
$
(300)
$
(400)
$
(900)
494
----------------------- Page 21-----------------------
July
c.
August
September
Total
Put Option C
......
287,500
........
Sales revenue .........................................................

$
287,500
$
Cost of sales .........................................................
(200,000)
(200,000)
Adjustment to cost of salesIntrinsic value at 7/1 of
$0 versus intrinsic value at 9/10 of $12,500
[10,000 ($30 $28.75)] ..........................................
12,500
12,5
00
....
100,000
Gross profit on sales .................................................

$
100,000
$
Time value of $500 at beg. vs. $600 at end ..............
100
100

$
(400)
(400)
(100)
(100)
........
99,600
Net gain (loss) .......................................................

$
100
$
(400) $
99,900
$
d.
Futures Contract D
[($9.94 $9.95) vs. ($9.90 $9.92) 10,000] ..........
100
$
100
[($9.90 $9.92) vs. ($9.87 $9.89) 10,000] ..........

[($9.87 $9.89) vs. ($9.84 $9.85) 10,000] ..........
$
(100)
(100)
........
e.
Net gain (loss) .......................................................

$
100
$
(100)
Interest Rate Swap

Variable interest income:
$
(6.8% $10,000,000 1/12 year) ............................

56,667
$
56,6
(6.8% $10,000,000 1/12 year) ............................

$
56,667
56,6
(6.7% $10,000,000 1/12 year) ............................

$
55,833
55,8
67
67
33
Settlement of fixed variable difference:
....
[(7% 6.8%) $10,000,000 1/12 year] .................

1,667
1,667
[(7% 6.7%) $10,000,000 1/12 year] .................

2,500
2,500
Net interest income ...................................................

$
56,667
$
58,334 $
58,333 ...................................................................
.......... $ 173,334
495
----------------------- Page 22-----------------------
PROBLEM M-7
(1)
20X2
Dec. 31
Interest Expense .........................................
.........................
800,000
Cash .................................................
................................
800,000
To record interest expense
[(7% + 1%) $20,000,000 1/2 year].
....................
..............
Interest Rate Swap Asset .................................

27,990
27,990
To record change in the value of the swap.
20X3
June 30
.........................
810,000
Cash .................................................
................................
810,000
To record interest expense [(7.1% + 1%)
$20,000,000 1/2 year].
Cash .....................................................
................................
10,000
..............
...................

37,001
Interest Rate Swap Asset .............................
47,001
To record settlement of the swap [(7.1% 7.0%)

$20,000,000 1/2 year] and the change in the value
of the swap.
..............

10,000
.........................
Interest Expense .....................................

10,000
To reclassify other comprehensive income to
earnings.
Dec. 31
.........................
790,000
Cash .................................................
................................
790,000
$20,000,000 1/2 year].
..............

10,331
Cash .................................................
................................
10,000
...................
Interest Rate Swap Asset .............................

331
To record settlement of the swap [(6.9% 7.0%)
$20,000,000 1/2 year] and the change in value
of the swap.

.........................
10,000
..............

10,000
earnings.
496
----------------------- Page 23-----------------------
20X4
June 30
.........................
780,000
Cash .................................................
................................
780,000
$20,000,000 1/2 year].
....................
Interest Rate Swap Asset .................................

19,342
..............

658
Cash .................................................
................................
20,000

.........................
20,000
..............

20,000
earnings.
(2)
Impact on Earnings of the Interest Rate Swap
Six-Month Pe
riod Ending
Dec. 31,
Dec. 31,
June 30,
June 30,
20X3
20X2
Total
20X4
20X3
Effective interest rate:

Without a hedge .............
7.9%
7.8%
With a hedge ..................
8.0
8.0
8.0%
8.1%
8.0
8.0
Interest expense:
0,000
Without a hedge .............

$790,000
$780,000
With a hedge ..................
800,000
800,000
$800,000
$3,180,000
$81
800,000
800,000
3,200
,0
10,000
00
Difference ......................
$(10,000)
$(20,000)
0
$
$
(20,0
Unfortunately, in retrospect, the company would have been better off not
to have engaged
in an interest rate swap. The swap resulted in an additional d
ecrease in earnings of
$20,000.
(3) The LIBOR rate on December 31, 20X3, would have had to be 7%. This would h
ave resulted in an 8% (7% + 1%) variable interest rate for the final 6-month pe
riod. If that were
the case, then total interest expense would have been $3,200,000 whether
or not there was
a hedge.
497

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----------------------- Page 1-----------------------

UNDERSTANDING THE ISSUES

1. The intrinsic value of a forward contract to

sell a commodity or currency is determined

by comparing the spot rate/price at the date

of inception of the forward to the spot

rate/price at a later valuation date. At date

of inception of the forward, the difference

tract. Both the intrinsic value and time value

per item must be multiplied by the notional

amount in order to calculate the respective

value of the option.

ire in unfavorable conditions. In the

terms. Therefore, if the price of the inventoterms.

more or less valuable than anticipated.

Keeping in mind that the price is fixed, a

ble if prices increase prior to execution of

the commitment. This exposure to loss may

be effectively hedged against through the

use of a derivative instrument such as a

contract or option to buy inventory. In a

highly effective hedge, the loss in value on

the firm commitment should be offset by

rate of LIBOR plus 2%. If LIBOR is

over time. For example, if an options total

----------------------- Page 2-----------------------

Notional amount in tons .............................

Strike price .................................................

Spot rate ....................................................

Intrinsic value (if spot is > strike) ................

Time value .................................................

Total value .................................................

Fixed interest ($3 million 8% 1/12 year) .....................

Number of bushels .....................................

Spot price/bushel ....................................... $

Future price/bushel .................................... $

Fair value of contract:

Intrinsic value (change in spot rates) ...

Time value (spot-forward difference)

Increase (decrease) in value of inventory ....

Gain (loss) on futures contract:

Number of bushels .....................................

Spot price/bushel .......................................

Future price/bushel ....................................

Fair value of contract:

Intrinsic value (change in spot rates) ...

Time value (spot-forward difference)

Increase (decrease) in value of inventory ....

Intrinsic value component .......................

Time value component ...........................

Net interest expense:

Settlement of rate difference:

Net interest expense ...............................................

Carrying value of note payable:

Carrying value of debt .............................................

Net unrealized gain (loss) on the swap ........................

(1) Critical criteria that must be satisfied in order to justify classificatio

At inception, the hedging relationship is identified and documented.

b. There is an expectation that the hedge will be highly effec

a. The option is for the same notional amount (100,000 bushels) as is th

Analysis of changes in the value of the put option:

Notional amount in tons ...................

Strike price .......................................

Time value .......................................