12 Fischer10e SM Module Final

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DERIVATIVES MODULE
UNDERSTANDING THE ISSUES
1. The intrinsic value of a forward contract to ue increases $700, then the time value has
sell a commodity or currency is determined decreased by $200. This $200 change
by comparing the spot rate/price at the date would be recognized in current income.
of inception of the forward to the spot Changes in the intrinsic value over time are
rate/price at a later valuation date. At date initially recorded as a component of other
of inception of the forward, the difference comprehensive income and therefore do
between the forward rate and spot not currently impact operating income.
represent the total time value of the con- However, these amounts will affect current
tract. Both the intrinsic value and time value operating income when the hedged item it-
per item must be multiplied by the notional self affects current operating income. For
amount in order to calculate the respective example, if the above option hedged a fo-
total values. recasted sale of inventory, changes in the
intrinsic value would not be recognized cur-
A 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 be-
tween these two values times the notional 4. Unlike a futures contract, an option contract
amount represents the total intrinsic value. represents a right, rather than an obliga-
The time value of an option is measured by tion. While the option contract requires the
subtracting the intrinsic value from the total holder to make an initial nonrefundable
value of the option. cash outlay, the holder can allow the option
to expire in unfavorable conditions. In the
2. A firm commitment to sell inventory is fixed
case of a futures contract, the contract
in terms of the quantity, price, and delivery
must be exercised even if on unfavorable
terms. Therefore, if the price of the invento-
terms.
ry changes prior to execution of the com-
mitment, the commitment may become 5. An interest rate swap involves exchanging
more or less valuable than anticipated. variable interest rates for fixed interest
Keeping in mind that the price is fixed, a rates or fixed interest rates for variable in-
commitment to sell will become less valua- terest rates. For example, assume that a
ble if prices increase prior to execution of company has borrowed $3 million at a vari-
the commitment. This exposure to loss may able interest rate of LIBOR plus 2% points.
be effectively hedged against through the Concerned that interest rates will increase,
use of a derivative instrument such as a the borrower could agree to pay a counter-
contract or option to buy inventory. In a party a fixed rate of interest in exchange for
highly effective hedge, the loss in value on receiving a variable rate of interest which
the firm commitment should be offset by will be paid to the original lender. For ex-
the gains in value on the derivative instru- ample, assume the borrower agrees to pay
ment. 6.5% fixed in exchange for receipt of a va-
riable rate of LIBOR plus 2%. If LIBOR is
3. A cash flow hedge of a forecasted transac-
greater than 4.5%, the borrower will gain
tion affects both current and future operat-
from the swap and effectively reduce their
ing income. The effect on current operating
interest expense to a fixed rate of 6.5%.
income is represented by the change in
However, if LIBOR is less than 4.5%, the
time value of the hedging instrument. This
borrower will be paying more than the vari-
is measured as the change in total value
able interest rate in that they have fixed
over time less the change in intrinsic value
their interest rate at 6.5%.
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 will be changes in the
time value of the option.
The impact on earnings for the first and second 30-day period is a charge against earnings of
$2,000 and $2,500, respectively, to be recognized as an unrealized loss on the hedge.
30 Days Expiration
Beginning Later Date
Notional amount in tons ............................. 500 500 500
Strike price ................................................. $1,200 $1,200 $1,200
Spot rate .................................................... $1,201 $1,214 $1,216
Intrinsic value (if spot is > strike) ................ $ 500 $7,000 $8,000
Time value ................................................. $4,500 $2,500
Total value ................................................. $5,000 $9,500 $8,000
Regarding the hedge against a fixed rate loan, the impact on earnings would be the fixed inter-
est expense as adjusted for the settlement of rate differences determined as follows:
First Next
30 Days 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
EXERCISE 2
Corn Futures
June 1 June 30 July 31
Number of bushels ..................................... 150,000 150,000 150,000
Spot price/bushel ....................................... $ 3.42 $ 3.41 $ 3.43
Future price/bushel .................................... $ 3.56 $ 3.53 $ 3.54
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, the contract has no in-
trinsic value. Therefore, the value of the contract must be traceable to time value.
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
Exercise 2, Concluded
Wheat Futures
June 1 June 30 July 31
Number of bushels ..................................... 150,000 150,000 150,000
Spot price/bushel ....................................... $ 6.20 $ 6.19 $ 6.175
Future price/bushel .................................... $ 6.35 $ 6.33 $ 6.32
futures price notional amount) .......... $ 3,000 $ 4,500
Value of contract .................................. 3,000 1,500
Intrinsic value (change in spot rates) ... 1,500 2,250

change in intrinsic value ................. 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:
Intrinsic value component ....................... $ 1,500 $ 2,250
Time value component ........................... 1,500 (750)
Total ....................................................... $ 3,000 $ 1,500
EXERCISE 3
20X3
June 30 December 31
(1) 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)
Net interest expense ............................................... $ 175,000 $ 170,000
(2) 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
EXERCISE 4
(1) Critical criteria that must be satisfied in order to justify classification 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 effective. 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 changes in value as com-
modity prices change that could affect earnings.
d. The hedge item (the commitment) is not being measured at fair value to reflect both
positive and negative changes in value (commitments that are not hedged are generally
only adjusted to reflect downward changes in value).
(2) Several factors that could suggest that the hedge is highly effective include the following:
a. The option is for the same notional amount (100,000 bushels) as is the commitment.
b. The delivery location for the option is not significantly different than the location for the
actual commitment.
c. Changes in corn price for delivery in a different location than the commitment 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. Therefore, if corn prices in-
crease above the strike price of $1.51 a bushel, the company is not obligated under the op-
tion to sell at the strike price. The only cost incurred by the company in that case is the ini-
tial cost of the option.
(4) The value of an option consists of two components: intrinsic value and time value. The for-
mer represents the extent to which the current spot price compares favorably 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 that the option ulti-
mately 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. Therefore, 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 cost.
(6) The initial time value component of an options value is allocated to earnings over the pe-
riod of the term of the option. The amount of time value allocated to each period is deter-
mined 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 value of the option the
intrinsic component of value leaving the time value component.
479
EXERCISE 5
(1) Analysis of changes in the value of the put option:
April 1 April 30 May 31 June 15

Notional amount in tons ................... 1,000 1,000 1,000 1,000
Strike price ....................................... $ 700 $ 700 $ 700 $ 700
Spot price......................................... 701 696 697 695
Intrinsic value (if strike is > spot) ..... 4,000 3,000 5,000
Time value ....................................... 1,000 300 500
Total value ....................................... 1,000 4,300 3,500 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
Investment in Option ........................................................ 1,000
Investment in Option ............................................................ 200
Unrealized Gain on Option ............................................... 200
($300 on April 30 vs. $500 on May 31).
480
June 15 Loss on Commitment ........................................................... 2,000

Firm Commitment ............................................................ 2,000
[($695 $697) 1,000].
Investment in Option ............................................................ 2,000
Unrealized Gain on Option ............................................... 2,000
($500 on May 31 vs. $0 on June 15).
Cash ..................................................................................... 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 totally effective.
The commitment would have still lost $5,000 and the option's intrinsic value would have
gained only $3,000 [($698 $695) 1,000].
481
EXERCISE 6
(1) Analysis of changes in the value of the call option:

February 20 February 28 March 31 April 20
Notional amount in pounds ........ 300,000 300,000 300,000 300,000
Strike price ................................. $ 1.60 $ 1.60 $ 1.60 $ 1.60
Spot price................................... 1.61 1.59 1.62 1.64
Intrinsic value (if strike
is < spot)............................. 3,000 6,000 12,000
Time value ................................. 800 1,200 800 500
Total value. ................................ 3,800 1,200 6,800 12,500
Feb. 20 Investment in Option ............................................................ 3,800

Cash ................................................................................. 3,800
To record payment of option premium.
28 Other Comprehensive Income.............................................. 3,000

Investment in Option ............................................................ 400
Unrealized Gain on Option ............................................... 400
($800 on February 20 vs. $1,200 on February 28).
Mar. 31 Investment in Option ............................................................ 6,000

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

($800 on March 31 vs. $500 on April 20).
Cash ..................................................................................... 12,500
482
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 follows:
Without the With the

Hedge Hedge
Assumed sales value ................................................................ $ 300,000 $ 300,000
Cost of sales ............................................................................. (244,500) (240,00
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 have been a $4,200 de-
crease in earnings.
483
EXERCISE 7
(b)
(1) (a) Interest (c)
Loan Balance Interest at Received from Interest Paid to
at Beginning of Original Counterparty Counterparty
Quarter Rate (4.5%) at Rate (4.2%) Rate Amount
Quarter 1 ................................... $120,000,000* $1,350,000 $1,260,000 4.25% $1,275,000
Quarter 2 ................................... 116,250,000 1,307,813 1,220,625 4.35 1,264,219
Quarter 3 ................................... 112,500,000 1,265,625 1,181,250 3.85 1,082,813
Quarter 4 ................................... 108,750,000 1,223,438 1,141,875 3.65 992,344
$5,146,876 $4,803,750 $4,614,376
*$150,000 ($3,750,000 8 quarters) = $120,000,000.
(2) (b)
Interest (a)
Loan Balance Received from Interest Paid to
at Beginning of Counterparty Counterparty (c)
Quarter at Rate (4.2%) Rate Amount Net Payment
Quarter 1 ................................... $105,000,000* $1,102,500 3.55% $ 931,875 $170,625
Quarter 2 ................................... 101,250,000 1,063,125 3.55 898,594 164,531
Quarter 3 ................................... 97,500,000 1,023,750 3.55 865,313 158,438
Quarter 4 ................................... 93,750,000 984,375 3.55 832,031 152,344
$4,173,750 $3,527,813 $645,938
*$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 at the beginning of the second year of the swap is
$632,120 [the net present value of the four net payments ($170,625; $164,531; $158,438; $152,344) discounted at 3.55%/4].
(4) As the floating rate decreases relative to the receive fixed rate, the value of the swap increases. If the spread between the re-
ceive fixed and pay floating begins to decrease, the value of the swap will decrease. The value of the swap is also influenced by
the amount of time remaining on the swap. In essence, the value of the swap reflects the present value of the anticipated net
payment over the remaining term of the swap.
484
Derivatives ModuleProblems
PROBLEMS
PROBLEM M-1
(1) The use of derivatives for speculative purposes is prohibited. Derivatives are used to man-
age 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 that which is
associated with cash flow hedges. Some of the hedges are used with respect to the varia-
bility in future cash flows attributable to changes in foreign currency 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 cash flows could
vary due to changes in prices or rates. The interest rate swaps that are used as cash flow
hedges are designed to hedge against the adverse effects of variability in cash flows asso-
ciated with existing debt that has variable interest rates or with forecasted transactions, as
is the case with the treasury lock agreements related to the anticipated fixed rate note is-
suance to finance the acquisition of York. A fair value hedge is used to offset changes in
the fair value of items with fixed prices or rates. The interest rate swaps 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 based 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, the 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 impact 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 to the basis of the debt.
Therefore, the net effect would be zero. However, the fixed interest expense on the debt
would be adjusted (increased or decreased) to reflect the settlement of interest rate differ-
ences. If the floating rate paid were less than the fixed rate received, the company would
experience a decrease in interest expense.
485
PROBLEM M-2
(1) Corn Futures September 1 September 30 October 31 November 5

Number of bushels. ........................ 1,000,000 1,000,000 1,000,000 1,000,000
Spot price per bushel ...................... $2.5000 $2.5380 $2.5680 $2.5685
Futures price per bushel ................. $2.5100 $2.5420 $2.5700 $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:
At beginning of period ....... $2,500,000 $2,538,000 $2,568,000
At end of period ................ 2,538,000 2,568,000 2,568,500
Change .................................. $ 38,000 $ 30,000 $ 500
(a) (b) = Change in spot-forward
difference ............................... $ (6,000) $ (2,000) $ 500
Wheat Futures September 1 September 30 October 31 November 5

Number of bushels. ........................ 2,000,000 2,000,000 2,000,000 2,000,000
Spot price per bushel ...................... $3.5150 $3.5480 $3.5700 $3.5700
Futures price per bushel ................. $3.5210 $3.5520 $3.5710 $3.5705
Fair value of contract ................... $ $ 62,000 $ 100,000 $ 99,000
(a) Change in above fair value .... $ 62,000 $ 38,000 $ (1,000)
(b) Change in spot rates:
At beginning of period ....... $7,030,000 $7,096,000 $7,140,000
At end of period ................ 7,096,000 7,140,000 7,140,000
Change .................................. $ 66,000 $ 44,000 $
(a) (b) = Change in spot-forward
difference ............................... $ (4,000) $ (6,000) $ (1,000)
Sept. 1 Memo entry to record the acquisition of the futures contract.

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
To record change in value of contract and
include in earnings change in time value
excluded from hedge effectiveness.
486
Problem M-2, Concluded
Oct. 31 Futures ContractCorn ....................................................... 28,000

Futures ContractWheat ..................................................... 38,000
Unrealized Hedging Loss ..................................................... 8,000
Nov. 5 Futures ContractCorn ....................................................... 1,000

Unrealized Hedging Loss ..................................................... 500
Futures ContractWheat ................................................ 1,000
Other Comprehensive Income ......................................... 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 with 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 than the quality of
the commodities used to make the flour acquired by CBBI.
d. The quantity of flour used by CBBI and therefore the equivalent amount of corn and
wheat may be greater than the notional amount of the futures contracts. Therefore,
some of the cash flows would not be hedged.
487
PROBLEM M-3
September Futures Contract

June 15 June 30 September
Number of gallons ...................................... 420,000 420,000 420,000
Spot price per gallon .................................. $ 2.09 $ 2.075 $ 2.12
Future price per gallon ............................... $ 2.10 $ 2.08
futures price notional amount) .......... $ 8,400 $
Value of contract .................................. 8,400 (8,400)
Intrinsic value (change in spot rates) ... 6,300 (6,300) (Note

A)

change in intrinsic value ................. 2,100 (2,100)
Note A: The contract expires in September; at that time, the spot/future rate is greater than the
contracted future rate. Therefore, the contract has no value at its expiration date.
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:
Change in intrinsic value ........................ $ 6,300 $ (6,300)
Change in time value .............................. 2,100 (2,100)
Total income statement values..................... $ 2,100 $ (2,100)
Balance sheet asset accounts:
Increase (decrease) in inventory .................. $ (6,300) $ 6,300
Increase (decrease) in futures contract ........ 8,400 (8,400)
488
October Futures Contract

Wheat Futures June 15 June 30 July 31
Number of bushels ............................. 630,000 630,000 630,000
Spot price per bushel ......................... $ 2.12 $ 2.146 $ 2.169
Future price per bushel ...................... $ 2.15 $ 2.18 $ 2.20
futures price notional amount) .. $ 18,900 $ 31,500
Value of contract .......................... 18,900 12,600
Intrinsic value (change in spot 16,380 14,490

rates) ..................................................
Time value (spot-forward differ-

ence)
or change in contract value
less
change in intrinsic value ......... 2,520 (1,890)
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.......... $ (13,104) $ (11,592) (Note
B)
Gain (loss) on firm commitment .......... (3,276) (2,898) (Note
C)
Gain (loss) on futures due to:
Change in intrinsic value ............... 16,380 14,490 (Note
D)
Change in time value ..................... 2,520 (1,890) (Note
D)
Total income statement values............ $ 2,520 $ (1,890)
Balance sheet asset accounts:
Increase (decrease) in inventory ......... $ (13,104) $ (11,592) (Note
B)
Increase (decrease) in firm commit- (3,276) (2,898) (Note
ment C)
Increase (decrease) in futures con- 18,900 12,600
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
490
PROBLEM M-4
(1) Interest
Date Payment Quarterly Rate Amount Principal Balance
December 31, 20X7 ....... $12,590,619
March 31, 20X8 ............. $1,136,408 1.25% $157,383 $ 979,025 11,611,594
June 30, 20X8................ 1,136,408 1.25 145,145 991,263 10,620,331
September 30, 20X8 ...... 1,136,408 1.25 132,754 1,003,654 9,616,677
December 31, 20X8 ....... 1,136,408 1.25 120,208 1,016,200 8,600,477
Totals ........................ $4,545,632 $555,490 $3,990,142
(2) Interest
Date Payment Quarterly Rate Amount Principal Balance
June 30, 20X8................ $10,000,000
September 30, 20X8 ...... $115,000 1.1500% $115,000 $ 10,000,000
December 31, 20X8 ....... 108,750 1.0875 108,750 10,000,000
Totals ........................ $223,750 $223,750 $
(3) Balance at
Beginning Pay Receive Net Swap Stated Interest Net Interest
Date of Quarter Floating Rate Fixed Rate Interest on Note Expense
March 31, 20X8 ............. $12,590,619 1.1875% 1.1875% $ $157,383 $157,383
June 30, 20X8................ 11,611,594 1.1625 1.1875(2,903) 145,145 142,242
September 30, 20X8 ...... 10,620,331 1.1000 1.1875(9,293) 132,754 123,461
December 31, 20X8 ....... 9,616,677 1.0375 1.1875 (14,425) 120,208 105,783
Totals ........................ $(26,621) $555,490 $528,869
(4) Balance at
Beginning Pay Receive Net Swap Stated Interest Net Interest
Date of Quarter Floating Rate Fixed Rate Interest on Note* Income
September 30, 20X8 ...... $10,000,000 1.1500% 1.1250% $(2,500) $122,500 $120,000
December 31, 20X8 ....... 10,000,000 1.0875 1.1250 3,750 116,250 120,000
Totals ........................ $ 1,250 $238,750 $240,000
*$10,000,000 x (2.90% + 2.0%)/4 = $122,500; $10,000,000 x (2.65% + 2.0%)/4 = $116,250.
491
(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 con-
cern due to changing currency exchange rates. If the interest income is to be received in euros and the euros are exchanged in-
to dollars, it is possible that the number of dollars received could decline over time. This would be the case if the euro weakened
relative to the dollar.
492
PROBLEM M-5
July 10 July 31 August 31 Sept. 10

Notional amount in troy ounces. .......... 100,000 100,000 100,000 100,000
Strike price ........................................... $5.00 $5.00 $5.00 $5.00
Spot price ............................................. $5.10 $5.14 $5.35 $5.32
Intrinsic value (if strike is < spot) .......... $10,000 $14,000 $35,000 $32,000
Time value ........................................... $10,000 $9,000 $2,000 $1,000
Total value ........................................... $20,000 $23,000 $37,000 $33,000
July 10 Investment in Call Option .................................................. 20,000

Cash ............................................................................ 20,000
To record payment of option premium
(100,000 $0.20).
31 Investment in Call Option .................................................. 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 Investment in Call Option .................................................. 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
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 August September Total

a. 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 ........ 400 400
Time value of $2,400 at beg. vs. $1,000 at end ........ (1,400) (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 accounting)
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
July August September Total

c. Put Option C
Sales revenue ............................................................... $ 287,500 $ 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 12,500
Gross profit on sales ..................................................... $ 100,000 $ 100,000
Time value of $500 at beg. vs. $600 at end .............. $ 100 100
Time value of $600 at beg. vs. $200 at end .............. $ (400) (400)
Time value of $200 at beg. vs. $100 at end .............. (100) (100)
Net gain (loss) ............................................................... $ 100 $ (400) $ 99,900 $ 99,600
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)
Net gain (loss) ............................................................... $ 100 $ (100)
e. Interest Rate Swap

Variable interest income:
(6.8% $10,000,000 1/12 year) ............................ $ 56,667 $ 56,667
(6.8% $10,000,000 1/12 year) ............................ $ 56,667 56,667
(6.7% $10,000,000 1/12 year) ............................ $ 55,833 55,833
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
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
To record change in the value of the swap.
20X3
June 30 Interest Expense .................................................................. 810,000
Cash ................................................................................. 810,000
To record interest expense [(7.1% + 1%)
$20,000,000 1/2 year].
Cash ..................................................................................... 10,000
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.
Interest Expense .............................................................. 10,000
To reclassify other comprehensive income to
earnings.
Dec. 31 Interest Expense .................................................................. 790,000

Cash ................................................................................. 790,000
$20,000,000 1/2 year].
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.
Interest Expense .................................................................. 10,000
earnings.
496
20X4
June 30 Interest Expense .................................................................. 780,000
Cash ................................................................................. 780,000
$20,000,000 1/2 year].
Interest Rate Swap Asset ..................................................... 19,342
Other Comprehensive Income.............................................. 658
Cash ................................................................................. 20,000
Interest Expense .................................................................. 20,000
earnings.
(2) Impact on Earnings of the Interest Rate Swap
Six-Month Period Ending

Dec. 31, June 30, Dec. 31, June 30,
20X2 20X3 20X3 20X4 Total
Effective interest rate:
Without a hedge ............. 8.0% 8.1% 7.9% 7.8%
With a hedge .................. 8.0 8.0 8.0 8.0
Interest expense:
Without a hedge ............. $800,000 $810,000 $790,000 $780,000 $3,180,000
With a hedge .................. 800,000 800,000 800,000 800,000 3,200,00
Difference ...................... $ 0 $ 10,000 $(10,000) $(20,000) $ (20,000
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 decrease in earnings of
$20,000.
(3) The LIBOR rate on December 31, 20X3, would have had to be 7%. This would have re-
sulted in an 8% (7% + 1%) variable interest rate for the final 6-month period. 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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UNDERSTANDING THE ISSUES

Intrinsic value (change in spot rates) ... 1,500 (1,500) (Note

Time value (spot-forward difference)

Intrinsic value (change in spot rates) ... 1,500 2,250

Time value (spot-forward difference)

(1) Analysis of changes in the value of the put option:

April 1 April 30 May 31 June 15

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

30 Loss on Commitment ........................................................... 4,000

May 31 Firm Commitment ................................................................. 1,000

June 15 Loss on Commitment ........................................................... 2,000

Without the With the

(1) Analysis of changes in the value of the call option:

Feb. 20 Investment in Option ............................................................ 3,800

28 Other Comprehensive Income.............................................. 3,000

Mar. 31 Investment in Option ............................................................ 6,000

Apr. 20 Investment in Option ............................................................ 6,000

May 3 Inventory of Soybean Meal ................................................... 489,000

June Cost of Sales ........................................................................ 240,000

Without the With the

*$150,000 ($3,750,000 8 quarters) = $120,000,000.

*$150,000 ($3,750,000 12 quarters) = $105,000,000.

(1) Corn Futures September 1 September 30 October 31 November 5

Wheat Futures September 1 September 30 October 31 November 5

Sept. 1 Memo entry to record the acquisition of the futures contract.

Problem M-2, Concluded

Oct. 31 Futures ContractCorn ....................................................... 28,000

Nov. 5 Futures ContractCorn ....................................................... 1,000

21 Other Comprehensive Income.............................................. 178,500

September Futures Contract

Intrinsic value (change in spot rates) ... 6,300 (6,300) (Note

Time value (spot-forward difference)

Problem M-3, Concluded

October Futures Contract

Intrinsic value (change in spot 16,380 14,490

Time value (spot-forward differ-

As a result of the above hedging activity, the

*$10,000,000 x (2.90% + 2.0%)/4 = $122,500; $10,000,000 x (2.65% + 2.0%)/4 = $116,250.

Problem M-4, Concluded

July 10 July 31 August 31 Sept. 10

July 10 Investment in Call Option .................................................. 20,000

31 Investment in Call Option .................................................. 3,000

Aug. 31 Investment in Call Option .................................................. 14,000

Sept. 10 Unrealized Loss on Hedge ................................................ 1,000

15 Inventory of Silver .............................................................. 533,000

Sept. Accounts Receivable ......................................................... 225,000

Problem M-5, Concluded

Sept. Other Comprehensive Income .......................................... 3,300

Oct. Accounts Receivable ......................................................... 750,000

July August September Total

Problem M-6, Concluded

July August September Total

e. Interest Rate Swap

Dec. 31 Interest Expense .................................................................. 790,000

Problem M-7, Concluded

(2) Impact on Earnings of the Interest Rate Swap

Six-Month Period Ending

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