NYU Stern School of Business | Full-time MBA, Part-time ...
Chapter 11
Derivative Financial Instruments:
Futures , Options and Financial Swaps
SUMMARY OF ASSIGNMENT MATERIAL
| | | | |
|Item |Topics Covered |Level |Time |
| | | | |
|Q11.1 |Apply SFAS 133 definition of financial instruments to callable convertible preferred |Mod |10-15 |
| |stock. | | |
| | | | |
|Q11.2 |Explain the four characteristics of derivative financial instruments specified in SFAS|Mod |10-15 |
| |133. | | |
| | | | |
|Q11.3 |Define derivative financial instrument; explain users= interests in an entity=s use of|Low |5-10 |
| |derivatives. | | |
| | | | |
|Q11.4 |Explain Ahedge accounting@ under SFAS 133. |Mod |10-15 |
| | | | |
|Q11.5 |Explanation of how futures contracts can also increase risk. |Low |10-15 |
| | | | |
|Q11.6 |Explain treatment of value changes of derivatives serving as (1) fair value hedges and|Mod |10-15 |
| |(2) cash flow hedges. | | |
| | | | |
|Q11.7 |Description of how options differ from futures and forward contracts. |Low |10-15 |
| | | | |
|Q11.8 |Explain the terms naked option writer and covered option writer, and discuss the risk |Mod |15-20 |
| |associated with each. | | |
| | | | |
|Q11.9 |Discuss how a put option can be used to hedge against movements in interest rates. |Mod |10-15 |
| | | | |
|Q11.10 |Discuss the most significant risk assumed by counterparties engaged in an interest |Mod |15-20 |
| |rate swap and how it can be avoided. | | |
SUMMARY OF ASSIGNMENT MATERIAL (cont=d.)
| | | | |
|Item |Topics Covered |Level |Time |
| | | | |
|Q11.11 |Describe obligation swapped by fixed rate payer and floating rate payer in plain |Mod |10-15 |
| |vanilla interest rate swap and factors motivating counterparties to enter an interest | | |
| |rate swap. | | |
| | | | |
|Q11.12 |Describe approach to valuing financial swaps and explain whether computed value is an |High |10-15 |
| |asset or liability. | | |
| | | | |
|Q11.13 |Discuss principal reasons for extensive disclosures about derivatives. |Low |5-10 |
| | | | |
|E11.1 |Journal entries for short futures contract; calculate profit without hedge. |Mod |20-25 |
| | | | |
|E11.2 |Assess initial and continuing hedge effectiveness and earnings impact. |Mod |15-20 |
| | | | |
|E11.3 |Journal entries for long futures contract; calculate gain/loss from hedging. |Mod |20-25 |
| | | | |
|E11.4 |Journal entries for short futures contract. |Low |10-15 |
| | | | |
|E11.5 |Economics of hedging with futures contracts; how hedging fixes the price paid; |Mod |15-20 |
| |propriety of hedge accounting. | | |
| | | | |
|E11.6 |Understanding economics of hedging with options; how hedging limits the price paid; |Mod |15-20 |
| |argue against use of hedge accounting. | | |
| | | | |
|E11.7 |Journal entries for interest rate cap and loan interest. |Mod |20-25 |
| | | | |
|E11.8 |Journal entries for put options on bonds. |Mod |25-30 |
| | | | |
|E11.9 |Journal entries for call options on foreign currency. |Mod |25-30 |
SUMMARY OF ASSIGNMENT MATERIAL (cont=d.)
| | | | |
|Item |Topics Covered |Level |Time |
| | | | |
|E11.10 |Assess hedge effectiveness when using options; financial statement effects. |Mod |20-30 |
| | | | |
|E11.11 |Interpretation of Disney financial instrument disclosures. |Mod |20-30 |
| | | | |
|E11.12 |Computation of annual interest rate advantage to companies involved in an interest |Mod |20-25 |
| |rate swap; resulting net interest rate spread. | | |
| | | | |
|E11.13 |Computation of monthly profit and effect of default on an interest rate swap. |Mod |20-25 |
| | | | |
|E11.14 |Journal entries for data in E11.13 assuming no default. |Mod |20-30 |
| | | | |
|E11.15 |Journal entries for debt and related interest rate swap; alternative scenario. |Mod |20-25 |
| | | | |
|P11.1 |Journal entries for short futures contract; calculate cash gain/loss on hedged |Mod |20-30 |
| |transaction; compare with cash gain/loss if futures contract was long. | | |
| | | | |
|P11.2 |Journal entries for interest rate futures; show how the futures fix the annualized |High |20-30 |
| |return on Treasury bill investment. | | |
| | | | |
|P11.3 |Apply interest rate futures in a fair value hedge; income statement effects, journal |Mod |25-35 |
| |entries; propriety of hedge accounting. | | |
| | | | |
|P11.4 |Advantages and disadvantages of hedging with futures contracts; point of indifference |High |25-35 |
| |between hedging and not hedging; show differential financial statement effects. | | |
SUMMARY OF ASSIGNMENT MATERIAL (cont=d.)
| | | | |
|Item |Topics Covered |Level |Time |
| | | | |
|P11.5 |Use data in P11.4 and explain advantages and disadvantages of hedging with options; |High |25-35 |
| |calculate point of indifference between hedging and not hedging; show differential | | |
| |financial statement effects. | | |
| | | | |
|P11.6 |Short answer questions on currency options. |High |20-30 |
| | | | |
|P11.7 |Present value analysis of desirability of interest rate cap under two scenarios; |High |30-40 |
| |journal entries for interest expense and the cap. | | |
| | | | |
|P11.8 |Journal entries for put options; calculation and timing of recognition of gain/loss |Mod |25-35 |
| |under SFAS 115. | | |
| | | | |
|P11.9 |Journal entries for put and call options used as straddle; calculate cash gain/loss on|Mod |25-30 |
| |straddle. | | |
| | | | |
|P11.10 |Determination of the viability and effect of interest rate swaps on the parties |Mod |30-40 |
| |involved in four different situations. | | |
| | | | |
|P11.11 |Evaluate strategies for hedging floating rate debt. |High |30-40 |
| | | | |
|P11.12 |Journal entries for interest rate swap; valuation and mark to market. |High |40-50 |
| | | | |
|P11.13 |Criticize and revise swap terms that are the reverse of what is needed; calculate cash|Mod |25-35 |
| |savings/loss produced by the swaps. | | |
| | | | |
|P11.14 |Analyze the differential effect of SFAS 133 on the reporting of futures, options, and |High |35-45 |
| |interest rate swaps. Discuss conditions favoring use of these derivatives in hedging.| | |
CARRYBACK TABLE
The carryback table identifies the assignment items which are new in this edition and those which are carried over from the seventh edition. For the latter, the problem number in the seventh edition is shown.
| | | | | | |
|New Problem Number | |New Problem Number | |New Problem Number | |
| | | | | | |
| |Source | |Source | |Source |
| | | | | | |
|Q11.1 |Q11.1 |E11.1 |E11.1 |P11.1 |P11.1 |
| | | | | | |
|Q11.2 |Q11.2 |E11.2 |E11.2 |P11.2 |P11.2 |
| | | | | | |
|Q11.3 |Q11.3 |E11.3 |E11.3 |P11.3 |P11.3 |
| | | | | | |
|Q11.4 |Q11.4 |E11.4 |E11.4 |P11.4 |P11.4 |
| | | | | | |
|Q11.5 |Q11.5 |E11.5 |E11.5 |P11.5 |P11.5 |
| | | | | | |
|Q11.6 |Q11.6 |E11.6 |E11.6 |P11.6 |P11.6 |
| | | | | | |
|Q11.7 |Q11.7 |E11.7 |E11.7 |P11.7 |P11.7 |
| | | | | | |
|Q11.8 |Q11.8 |E11.8 |E11.8 |P11.8 |P11.8 |
| | | | | | |
|Q11.9 |Q11.9 |E11.9 |E11.9 |P11.9 |P11.9 |
| | | | | | |
|Q11.10 |Q11.10 |E11.10 |E11.10 |P11.10 |P11.10 |
| | | | | | |
|Q11.11 |Q11.11 |E11.11 |new |P11.11 |new |
| | | | | | |
|Q11.12 |Q11.12 |E11.12 |E11.12 |P11.12 |P11.12 |
| | | | | | |
|Q11.13 |Q11.13 |E11.13 |E11.13 |P11.13 |P11.13 |
| | | | | | |
| | |E11.14 |E11.14 |P11.14 |new |
| | | | | | |
| | |E11.15 |E11.15 | | |
Carryforward tables for all chapters, identifying the disposition of seventh edition assignment items, appear at the beginning of the solutions manual.
ANSWERS TO QUESTIONS
Q11.1
The holder of callable convertible preferred stock has the contractual right to convert the preferred stock to common stock in accordance with a known formula or conversion ratio. Provision (1) in the financial instrument definition refers to this contractual conversion right.
Existence of the call provision, however, provides the issuer with flexibility that may rebound to the disadvantage of the holder. A callable security generally has a call price higher than issue price or par value. Nevertheless, by calling the stock the issuer can force conversion into common stock where a variable common dividend replaces a fixed preferred dividend. Or, if the conversion ratio is unfavorable to the holder, the holder is forced to relinquish the convertible preferred stock and possibly to incur additional transaction costs to obtain replacement investments.
Q11.2
1. Derivatives are tied to underlyings, variables that are subject to price changes. Thus derivatives are not tied to assets or liabilities themselves, but to the prices of those assets or liabilities.
2. Derivatives are based on a contractual or notional amount, a quantity of units to which the change in the underlying is applied.
3. Derivatives require either no initial investment or a nominal amount, not an amount approximating the value of the notional amount.
4. Derivatives provide for net cash or cash-equivalent settlement. Delivery of the notional amount is not required and the position can be settled by entering an offsetting derivative contract or by making a net cash payment equal to the product of the change in the underlying and the notional amount.
Q11.3
A derivative financial instrument is a financial instrument whose value is tied to or derived from the value of an underlying asset, financial instrument or other reference item.
Forward contracts, futures contracts, options and swaps are derivative financial instruments studied in this text.
We learned that derivatives can serve as hedges or as speculative investments. Because derivatives can be complex, they may expose the entity to losses not contemplated by users of financial statements. These users, particularly investors and creditors seeking to assess risk, should be interested in the exposure created by derivatives and their purpose--hedging or speculation.
Q11.4
Hedge accounting entails matching the recognition of gains and losses on derivatives that qualify as hedges with the gains and losses recognized on hedged items. The objective is to report gains/losses on hedge derivatives and hedged items in the same period=s earnings. This is done by (1) currently recognizing value changes in both the hedge and the hedged item (fair value hedges) or (2) initially recognizing the hedge=s value changes in other comprehensive income and later releasing these value changes into earnings when the gains/losses on the hedged items are recognized in earnings (cash flow hedges). Hedge accounting can be used when:
1. The item to be hedged exposes the company to price, currency or interest rate risk.
2. Hedging is sufficiently effective in reducing the company's exposure to these risks.
3. The hedge position is designated as a hedge.
Q11.5
Futures contracts will reduce risk when the price behavior of the futures contract correlates positively with the price behavior of the item being hedged.
For example, when hedging an owned asset you would sell futures (go short). Suppose the price of the owned asset--the hedged item--declines and the futures price also declines. In this case, the gain realized on closing the futures position by purchasing futures offsets the loss incurred on the owned asset.
Therefore, when there is negative correlation between the price of the futures and the price of the hedged item, and when a futures contract is used for speculative purposes, the use of futures contracts increases the risk of loss.
Q11.6
Fair value hedges are hedges of changes in the fair values of existing assets, liabilities or firm commitments. Value changes in the hedge derivative and the hedged item are recognized as offsetting gains and losses in current earnings.
Cash flow hedges are hedges of the cash flows expected from forecasted or probable anticipated transactions. Value changes in the hedge derivative are initially reported in other comprehensive income and released to earnings when the forecasted transaction is recognized and affects earnings.
Q11.7
Options differ from both futures and forward contracts in that the owner of the option has no obligation to perform. The option's writer does guarantee to perform, however, and receives a fee (premium) as compensation.
Q11.8
The writer of an option is said to be covered when the item underlying the option is owned. The writer is said to be naked when the optioned item is not owned.
The writer of a covered option is essentially hedged; the limited exposure to risk consists of any lack of correlation between movements in the prices of the
optioned item and the option. In contrast, the writer of a naked option has essentially taken a speculative position with unlimited risk. If the option is exercised, the writer will have to buy or sell the optioned item in the market at the (presumably unfavorable) prevailing market price.
Q11.9
A put option on bonds is used to hedge against a rise in interest rates. The put option gives the holder the right to sell the bonds at the strike price. The strike price on the bonds is expressed as a percentage of par which reflects an interest yield. When interest rates rise, the bonds' price falls; if it goes below the strike price, exercise of the put enables the holder to sell the bonds at the (higher) strike price and avoid the loss created by the rise in interest rates.
Q11.10
The most significant risk assumed by the counterparties in an interest rate swap is credit risk; namely, that the other party to the swap will not perform. Counterparties may avoid this risk by engaging an intermediary who will assume the credit risk for a fee. In many cases collateral is required to protect against default by the other party.
Q11.11
In a plain vanilla interest rate swap, one counterparty swaps a floating rate obligation for a fixed rate obligation and the other counterparty swaps a fixed rate obligation for a floating rate obligation. The party swapping the floating rate obligation becomes the fixed rate payer and the party swapping the fixed rate obligation becomes the floating rate payer.
The principal motivation is to obtain fixed or variable rate financing at a cost lower than that incurred by borrowing directly. Normally the counterparties also seek to use swaps to hedge their cash flows. Thus a firm with variable dollar inflows might swap a fixed interest rate payments for floating rate
interest payments, thereby creating an approximate hedge of the variable inflows by the variable outflows.
Q11.12
As separate financial instruments, swaps consist of two sets of cash flows. In a currency swap, one set of cash flows is in foreign currency and the other in dollars. In an interest rate swap, one set of cash flows is fixed and the other is variable. The basic valuation principles are:
Currency Swap
Value of currency swap = dollar equivalent of foreign currency flows - dollar- denominated flows
In a currency swap, the only component that changes is the dollar equivalent of the foreign currency flows. Discounting is required for multi-period swaps. The presence of an asset or liability depends on whether the instrument has a net debit or credit balance.
For example, when a U.S. company swaps foreign currency for dollars, we have the equivalent of a forward sale contract. As long as the debit balance of dollars due from the counterparty under the terms of the swap exceeds the dollar equivalent of the foreign currency to be transferred to the counterparty, the entity has an asset called Investment in Forward Contract.
Q11.12 (cont=d.)
Interest Rate Swap
Value of interest rate swap = PV of fixed rate flows - PV of floating rate flows
In an interest rate swap, the PV of the fixed rate flows changes as the current market (discount) rate changes but the PV of the floating rate flows does not. If the interest (discount) rate goes down, so does the floating interest payment, and vice versa; the effect of the changed discount rate is offset by the effect of the changed interest payment and the PV remains unchanged at par or face value. Again, the presence of an asset or liability depends on whether the instrument has a debit or credit balance.
For example, the floating rate payer (liability) is the fixed rate receiver (asset). As long as the "debit balance" of the PV of fixed interest payments exceeds the (unchanging) PV of the floating interest payments, the entity has an asset called Investment in Swaps.
Q11.13
Companies= positions in financial instruments were traditionally recognized only partially or not at all in companies' balance sheets. These instruments must now be fully recognized and carried at their fair values in the accounts.
SFAS 107 and SFAS 133 aim to provide financial statement users with more information about a company's positions in financial instruments. Even though most financial instruments are now carried at fair value, they are often not reported in financial statements as separate line items. These disclosures help explain companies uses of derivatives, their fair values and the financial statement effects of value changes, providing a more complete picture of financial health and performance. The disclosures should facilitate more informed assessments of companies' risk profiles.
SOLUTIONS TO EXERCISES
E11.1 COMMODITY FUTURES (SHORT) ENTRIES, PROFIT CALCULATION
Requirement 1:
January 6, 20X6
|Investment in Futures | |10,000 | |
| |Cash | |10,000 |
To record the initial margin deposit on the sale of commodity futures.
February 19, 20X6
|Loss on Hedge Activity | |11,000 | |
| |Cash | |11,000 |
To pay additional cash to the broker to cover the loss of
$11,000 (= $171,000 - $160,000) realized on the decline in
value of the futures contracts.
|Inventory | |11,000 | |
| |Gain on Hedge Activity | |11,000 |
To adjust the carrying value of the hedged inventory to fair value.
|Cash | |10,000 | |
| |Investment in Futures | |10,000 |
To record receipt of $10,000 from the broker, the initial
deposit which is returned after the futures are closed.
March 2, 20X6
|Cash (or Accounts Receivable) | |173,500 | |
| |Sales | |173,500 |
To record sale of commodities.
|Cost of Goods Sold | |161,000 | |
| |Inventory | |161,000 |
To charge the inventory sold to cost of sales. (Students would
omit this entry if they assumed a periodic inventory system).
E11.1 (cont=d.)
Requirement 2:
If Marcelino had not hedged by selling futures short, it would have avoided the $11,000 loss sustained when the short futures sold for $160,000 were closed by purchasing an offsetting long contract for $171,000. Marcelino's profit, which was $12,500 (= $173,500 - $161,000) under the hedge, would therefore have increased by $11,000 to $23,500 (= $173,500 - $150,000 inventory acquisition cost) if the hedge was not undertaken.
E11.2 ANALYZING HEDGE EFFECTIVENESS: FUTURES
Requirement 1:
High hedge effectiveness is achieved when, as stated in the problem, movement in the futures price offsets 110% of the movement in the spot price; exact 100% offset is not required.
Requirement 2:
Hedge effectiveness measure = change in fair value of hedge instrument
change in fair value of hedged item
Hedge effectiveness measure = ($10.30 - $10.40) X 100,000
($10.50 - $10.35) X 100,000
= ($10,000)/$15,000
= - 67%
The numerator shows the change in the spot price componentCthe hedge instrument in this caseCwhereas the denominator is the change in the commitment valued at the futures price. This hedge is no longer highly effective and hedge accounting is discontinued effective as of the last date high effectiveness was demonstrated. The futures contract is now a speculative instrument and the change in fair value of the futures contract is recognized in earnings. The creation of an offset by revaluing the firm commitment no longer exists when hedge accounting terminates.
E11.2 (cont=d.)
Requirement 3:
Since the hedge was last effective at inception, the $15,000 loss on the futures contract since inception is recognized in current earnings without offset from revaluing the firm commitment.
NOTE: Even though the spot price component of the futures price was designated as the hedge instrument, revaluation of the firm commitment is based on the change in the futures price, not the change in the spot price. Had the hedge been highly effective, the earnings impact would be zero even without perfect effectiveness because both the futures contract and the firm commitment are valued at the futures price.
E11.3 COMMODITY FUTURES (LONG) JOURNAL ENTRIES
Requirement 1:
The long position in the futures contract hedges an existing liability, the deferred revenue, and serves as a fair value hedge. A value change of $10,000 [= ($11 - $10) 10,000] is realized on June 30, representing a gain on the futures contracts and a loss on the exposed liability. A further value change of $5,000 [= ($11.50 - $11) 10,000] is realized on August 29, which also is a gain on the futures contracts and a loss on the exposed liability. When the commodities are shipped to the customer, the deferred revenue, which now includes the total value change (loss) of $15,000, will be recognized as realized revenue.
June 1, 20X6
|Investment in Futures | |10,000 | |
| |Cash | |10,000 |
To record the initial margin deposit on the purchase of
commodity futures.
E11.3 (cont=d.)
June 30, 20X6
|Investment in Futures | |10,000 | |
| |Gain on Hedge Activity | |10,000 |
To record the $10,000 [= 10,000 X ($11-$10)] gain on the
long position hedging deferred revenue, an existing liability.
|Loss on Hedge Activity | |10,000 | |
| |Liability (Deferred Revenue) | | |
| | | |10,000 |
To record in earnings the increase in the fair value of the
commodities needed to settle the liability.
August 29, 20X6
|Investment in Futures | |5,000 | |
| |Gain on Hedge Activity | |5,000 |
To record the $5,000 [= 10,000 X ($11.50-$11)] gain on the
long position hedging deferred revenue, an existing liability.
|Loss on Hedge Activity | |5,000 | |
| |Liability (Deferred Revenue) | | |
| | | |5,000 |
To record in earnings the increase in the fair value of the
commodities needed to settle the liability.
|Cash | |25,000 | |
| |Investment in Futures | |25,000 |
To record receipt of the margin deposit from the broker,
increased by the gains on the futures contracts;
$25,000 = $10,000 + $10,000 + $5,000.
E11.3 (cont=d.)
Requirement 2:
Even though Daley intends to purchase the commodity in the spot market, the purchase of futures locks in the ultimate price paid at $10.00. Daley received $150,000 from the customer; without hedging any increase in the spot price reduces Daley's ultimate profit on the transaction. With hedging, if the commodity's price increases, the gain on the long futures position offsets the loss created by having to purchase the commodity at that higher price.
Without Hedging:
|Cost of commodity at spot price ($11.50 X 10,000) |$115,000 |
With Hedging:
| Spot price paid ($11.50 X 10,000) |$115,000 |
|Realized gain on futures contract [($11.50 - 10) X 10,000] | (15,000) |
|Net cost of commodity |$100,000 |
|Amount saved by hedging |$ 15,000 |
E11.4 COMMODITY FUTURES (SHORT) JOURNAL ENTRIES
The short position in the futures contract hedges a firm sale commitment and is a fair value hedge.
June 1, 20X2
|Investment in Futures | |10,000 | |
| |Cash | |10,000 |
To record the initial margin deposit of $10,000 paid to the broker.
June 30, 20X2
On June 30, 20X2, Keister realizes a gain of $20,000 [= ($5 - $4.80) 100,000] on its short position and a $20,000 loss in value of the firm sale commitment.
E11.4 (cont=d.)
|Investment in Futures | |20,000 | |
| |Gain on Hedge Activity | |20,000 |
To mark the short futures position to market and recognize
the gain in earnings.
|Loss on Hedge Activity | |20,000 | |
| |Firm Commitment | |20,000 |
To recognize the loss on the firm sale commitment due to
a decline in selling prices.
August 29, 20X2
A further gain of $5,000 [= ($4.80 - $4.75) 100,000] is realized on the short futures; it, and the related loss on the firm sale commitment, are recognized.
|Investment in Futures | |5,000 | |
| |Gain on Hedge Activity | |5,000 |
To mark the short futures position to market and recognize
the resulting gain.
|Loss on Hedge Activity | |5,000 | |
| |Firm Commitment | |5,000 |
To recognize the loss on the firm sale commitment due to
a decline in selling prices.
|Commodities Inventory | |460,000 | |
| |Cash | |460,000 |
To record purchase of the commodities.
September 28, 20X2
The futures= loss in value of $2,000 [= $4.77 - $4.75) 100,000] accruing since August 29 and the offsetting gain on the firm sale commitment are recorded. Also, the short position is closed out and the $33,000 (= $10,000 + $20,000 + $5,000 - $2,000) margin deposit is returned by the broker.
E11.4 (cont=d.)
|Loss on Hedge Activity | |2,000 | |
| |Investment in Futures | |2,000 |
To mark the futures contract to market.
|Firm Commitment | |2,000 | |
| |Gain on Hedge Activity | |2,000 |
To recognize the gain on the firm sale commitment due to
a price increase.
|Cash | |33,000 | |
| |Investment in Futures | |33,000 |
To close out the short futures position and recover from the
broker the initial margin deposit of $10,000, increased by
realized gains of $23,000.
NOTE: When the sale occurs, the firm commitment liability is closed to Sales Revenue, increasing it by $23,000.
E11.5 ECONOMICS OF HEDGING WITH FUTURES; HEDGE ACCOUNTING
Requirement 1.
If McVeigh purchases the commodity for $4 per unit and closes out its long futures position for $4 per unit, McVeigh incurs a cash loss of $1.50 (= $5.50 - $4). Added to the per-unit commodity cost of $4, the $1.50 loss increases the cost per unit to $5.50.
Similarly, if McVeigh purchases the commodity for $6 per unit and closes out its long futures position for $6 per unit, McVeigh realizes a cash gain of $.50 (= $6 - $5.50) per unit. Subtracting this $.50 gain from the unit cost of $6 leaves the net cost of the commodity at $5.50 per unit.
Requirement 2:
In this case, McVeigh grows the commodity on its own farms, and may cover its delivery commitment with its own inventory. However, SFAS 133 requires only that the futures be designated as a hedge of the purchase commitment. The existing inventory is irrelevant. (NOTE: Under prior practice the long futures position is redundant, given the inventory. Hence the long position would be considered speculative, and hedge accounting would be prohibited.)
E11.6 ECONOMICS OF HEDGING WITH OPTIONS; HEDGE ACCOUNTING
Requirement 1:
Call options allow the holder to avoid loss if the price of the optioned item rises but to realize gain if the price of the optioned item falls (see Panels D, E and F in Figure 11.2). The cost of accomplishing this is the premium paid for the options. Purchase of 100,000 calls for $45,000 means that $.45 is added to the unit cost of the commodities when purchased.
If the commodity is bought in the spot market for $4.00, the option is not exercised and the option's premium increases the commodity's unit cost to $4.45. If the commodity's price is $6.00, (a) the options can be exercised and the commodity purchased at $5.50 or (b) the options can be sold for a gain of $.50 in intrinsic value, reducing unit cost of the commodity on the spot market to $5.50 (= $6.00 - $.50). Whichever action is taken, the $.45 premium increases the cost of the commodity to $5.95 (= $5.50 + $.45).
Requirement 2:
One could argue that an option possesses both a risk-reducing component and a speculative component. The upward sloping diagonal line in the upper-right hand quadrant of Panel D in Figure 11.2 provides the risk reduction by offsetting the corresponding loss in Panel E. The horizontal line to the left of the origin in Panel D--viewed as the speculative component--has no effect on the profit potential on the underlying exposure shown in the upper right-hand quadrant of Panel E. Thus a purist might argue against hedge accounting for options because of the inherent profit potential in the underlying exposure when the price of the optioned item falls (calls) or rises (puts).
This concern has not invalidated the use of hedge accounting as long as the options provides protection against loss and qualify as hedges. The premium paid further signifies the insurance aspect of options.
E11.7 INTEREST RATE CAP: JOURNAL ENTRIES
July 2, 20X1
|Investment in Interest Rate Cap | |18,000 | |
| |Cash | |18,000 |
To record premium paid on 7.1% interest rate cap payable
in full immediately; $18,000 = $3,000,000 X 0.003 X 2.
December 31, 20X1
|Interest Expense | |105,000 | |
| |Interest Payable | |105,000 |
To record interest payable on the loan for the first six months;
$105,000 = $3,000,000 X .07 X .5.
|Loss on Options | |11,000 | |
| |Investment in Interest Rate Cap | |11,000 |
To recognize the decline in fair value of the time value
portion of the premium; $11,000 = $18,000 - $7,000. The
cap remains out of the money and still has no intrinsic value.
June 30, 20X2
|Interest Expense | |109,500 | |
| |Interest Payable | |109,500 |
To record interest payable on the loan for the year;
$109,500 = $3,000,000 X .073 X .5.
|Investment in Interest Rate Cap | |1,000 | |
|Loss on Options | |2,000 | |
| |Interest Expense | |3,000 |
To record the $1,000 increase in fair value of the interest
rate cap. The cap goes in the money by $3,000
[= $3,000,000 X (.073 - .071) x .5] but loses $2,000 of its
time value; $2,000 = $18,000 - $11,000 - $5,000. NOTE:
The $3,000 increase in intrinsic value (gain) reduces interest
expense to $106,500 (= .5 x .071 x $3,000,000 = $109,500 - $3,000)
and the $2,000 decrease in time value is a loss.
E11.7 (cont=d.)
|Cash | |3,000 | |
| |Investment in Interest Rate Cap | |3,000 |
To record collection of the excess interest due under the
interest rate cap agreement.
E11.8 PUT OPTIONS: JOURNAL ENTRIES
March 1, 20X1
|Investment in Options | |6,200 | |
| |Cash | |6,200 |
To record purchase of put options; $6,200 = 2,000 X $3.10.
June 30, 20X1
|Loss on Hedge Activity | |3,600 | |
| |Investment in Options | |3,600 |
To record the loss on options hedging an investment in
government bonds; ($3,600) = 2,000 ($1.30 - $3.10).
|Investment in Bonds | |4,000 | |
| |Gain on Hedge Activity | |4,000 |
To adjust carrying value of the bond investment by the
increase in intrinsic value and report the offsetting gain in
earnings; $4,000 = (1.00 - 0.98) X $200,000.
.
December 31, 20X1
|Investment in Options | |6,000 | |
| |Gain on Hedge Activity | |6,000 |
To record the gain on options hedging an investment in
government bonds; $6,000 = 2,000 X ($4.30 - 1.30).
E11.8 (cont=d.)
|Loss on Hedge Activity | |6,000 | |
| |Investment in Bonds | |6,000 |
To adjust the investment in bonds to its current fair value;
$6,000 = (.97 - 1.00) X $200,000.
|Cash | |8,600 | |
| |Investment in Options | |8,600 |
To record the sale of put options; $8,600 = 2,000 X $4.30
= $6,200 - $3,600 + $6,000.
Alternate Entry to Record Sale of Options
|Cash | |8,600 | |
| |Investment in Options | |2,600 |
| |Gain on Hedge Activity | |6,000 |
To record sale of put options; carrying amount prior to
revaluation at December 31, 20X1 is $2,600 (= $6,200 - $3,600).
E11.9 CURRENCY CALLS: JOURNAL ENTRIES, HEDGE EFFECTIVENESS
Requirement 1:
July 1, 20X1
|Investment in Options | |28,000 | |
| |Cash | |28,000 |
To record purchase of call options; $28,000 = 2,000,000 X $.014.
December 31, 20X1
|Investment in Options | |110,000 | |
| |Gain on Hedge Activity | |110,000 |
To record gain on foreign currency call options hedging
,2,000,000 note payable; $110,000 = ($.069 - .014) X 2,000,000.
E11.9 (cont=d.)
|Loss on Hedge Activity | |100,000 | |
| |Loan Payable | |100,000 |
To accrue transaction loss on loan payable;
$100,000 = ($1.55 - $1.50) X 2,000,000.
June 30, 20X2
|Investment in Options | |102,000 | |
| |Gain on Hedge Activity | |102,000 |
To record gain on foreign currency call options hedging
,2,000,000 note payable; $102,000 = ($.12 - $.069) X 2,000,000.
|Loss on Hedge Activity | |120,000 | |
| |Loan Payable | |120,000 |
To accrue transaction loss on loan payable; $120,000 =
($1.61 - $1.55) X 2,000,000.
|Cash | |240,000 | |
| |Investment in Options | |240,000 |
To record the sale of put options; $240,000 = 2,000,000
X $.012 = $28,000 + $110,000 + $102,000.
Alternate Entry to Record Sale of Options
|Cash | |240,000 | |
| |Investment in Options | |138,000 |
| |Gain on Hedge Activity | |102,000 |
To record sale of put options; carrying amount prior to
revaluation at June 30, 20X2 is $138,000 = $28,000 + $110,000.
E11.9 (cont=d.)
Requirement 2:
Hedge effectiveness measure = change in fair value of hedge instrument
change in fair value of hedged item
At December 31, 20X1, the hedge effectiveness measure is - 1.1
[= $110,000/($100,000)], indicating high effectiveness.
At June 30, 20X2, the hedge effectiveness measure is -.85
[= $102,000/($120,000)], indicating continuing high hedge effectiveness.
NOTE: Technically hedge accounting does not apply here, as foreign-currency- denominated obligations are automatically restated to fair value under SFAS 52.
E11.10 ANALYZING HEDGE EFFECTIVENESS: OPTIONS
Requirement 1:
Historic information that the change in intrinsic value of the hedge instrument correlates with .95 of the change in the commodity=s spot price indicates high hedge effectiveness at inception.
Requirement 2:
Hedge effectiveness measure = change in fair value of hedge instrument
change in fair value of hedged item
= $30,000 (intrinsic value only)
-($2.027 - $2) X 1,000,000
= $30,000/($27,000) = -1.11
Thus the high hedge effectiveness test continues to be met.
E11.10 (cont=d.)
NOTE: at inception the options are at the money and the total $60,000 premium is time value. On September 30 the premium declined by $5,000 (= $55,000 - $60,000) consisting of a $30,000 increase in intrinsic value (from $0) and a $35,000 decrease in time value [($55,000 - $30,000) - $60,000].
Requirement 3:
|Income Statement: | |
|Loss on Options ($35,000 - $30,000) |$ 5,000 |
|Loss on Firm Commitment Liability | 27,000 |
|Net Loss |$32,000 |
Equivalently, there is a $35,000 loss on the time value (non-hedge) component of the options= value, a $30,000 gain on the intrinsic value (hedge) component and a $27,000 loss due to the increase in the fair value of the firm commitment liability. The $32,000 net loss can also be viewed as the $35,000 reduced by the $3,000 (= $30,000 - $27,000) gain on the ineffective portion of the hedge.
|Balance Sheet: |Dr. (Cr.) |
|Investment in Options |$55,000 |
|Firm Commitment |(27,000) |
|Retained Earnings |32,000 |
|Cash (reduced by $60,000 premium paid) |(60,000) |
E11.11 INTERPRETING FINANCIAL INSTRUMENT DISCLOSURES
Requirement 1:
Pay-floating swaps are receive-fixed swaps. These are (a) fair value hedges and (b) their value changes enter current earnings, presumably offset by the value change in the fixed-rate debt they are hedging.
Pay-fixed swaps are receive-floating swaps. These are (a) cash flow hedges and (b) their value changes initially enter other comprehensive income. Later, as the future variable interest payments on the hedged floating-rate debt are made, portions of the value change are reclassified into earnings to offset the changes in those payments.
Interest rate caps are options. These are (a) cash flow hedges against rising interest payments on floating-rate debt and (b) their value changes enter current earnings. Increases in intrinsic value occur when the interest rate rises above the rate specified in the cap and are credited to the (higher) interest expense. Changes in the time value enter earnings through interest expense or an Aother@ expense.
Requirement 2:
Above the second tabular display Disney notes that Athe company uses option strategies that provide for the sale of foreign currencies to hedge probable, but not firmly committed, revenues.@ Thus these are foreign currency puts, options to sell foreign currencies for dollars. In the third tabular display we see that foreign exchange options have a positive (asset) fair value of $39 million at September 30, 2000, higher than their carrying amount. These will rise in value as the dollar price of the foreign currenciesCthe direct exchange rateCfalls. Apparently the optioned currencies weakened and the indirect rateCforeign currency price of dollarsCincreased.
E11.12 BENEFITS OF INTEREST RATE SWAP
Advantage to Apricot, Inc.:
Inflows: floating rate from Nectar LIBOR + 30 8.3%
Outflows: fixed rate to Nectar 9.5%
floating rate on debt LIBOR + 30 8.3%
Total outflows: 17.8%
Actual fixed interest cost with swap 9.5%
Alternative financing: fixed rate on new debt 11.0%
Advantage due to swap 1.5%
Advantage to Pear, Inc.:
Inflows: fixed rate from Nectar 9.2%
Outflows: fixed rate on debt 9.2%
floating rate to Nectar LIBOR + 50 8.5%
Total outflows 17.7%
Actual floating interest with swap 8.5%
Alternative financing: fixed rate on existing debt 9.2%
Advantage due to swap 0.7%
Spread to Nectar Interbank:
Inflows: fixed rate from Apricot, Inc. 9.5%
floating rate from Pear, Inc. LIBOR + 50 8.5%
Total Inflows 18.0%
Outflows: floating rate to Apricot, Inc. LIBOR + 30 8.3%
fixed rate to Pear, Inc. 9.2%
Total Outflows 17.5%
Net interest rate spread 0.5%
E11.13 INTEREST RATE SWAP: PROFIT AND DEFAULT
Requirement 1:
Meno Bank's Inflows and Outflows:
Inflows: floating rate from Queen LIBOR + 30 6.6%
fixed rate from Prince T + 40 6.4%
Total inflows 13.0%
Outflows: fixed rate to Queen T + 30 6.3%
floating rate to Prince LIBOR + 20 6.5%
Total Outflows 12.8%
Net interest rate spread 0.2%
With a .2% net spread, Meno Bank was earning $2,000 (= .002 X $1,000,000) a year or approximately $167 a month.
Requirement 2:
Meno Bank receives T + 40 from Prince, the equivalent of 6.4% when T = 6%, while it is paying LIBOR + 20, the equivalent of 6.5% when LIBOR = 6.3%. Thus the money the bank was making was derived from its arrangements with Queen - not Prince. When LIBOR increases by 20bp, the floating rate rises to 6.7% (= LIBOR of 6.3% + 20 + 20) and the bank's loss on the arrangement with Prince increases to 0.3% (= 6.7% - 6.4%). After Queen's default, Meno Bank is losing $3,000 a year or $250 a month; $250 = (.003 X 1,000,000)/12.
E11.14 INTEREST RATE SWAP: JOURNAL ENTRIES
This is a plain vanilla swap. Under SFAS 133 Queen has a fair value hedge because it receives fixed from the bank and pays variable to the bank. In contrast, Prince has a cash flow hedge because it receives variable from the bank and pays fixed to the bank.
September 30, 20X8
Queen Corp.
|Interest Expense | |750 | |
| |Cash | |750 |
To record net cash payment made to Meno Bank;
($750) = [(.063 - .066) X $1,000,000]/4.
|Loss on Hedge Activity | |75,000 | |
| |Investment in Swaps (or Swap Liability) | | |
| | | |75,000 |
To mark to market interest rate swap serving as a fair value
hedge; unrealized loss affects earnings.
Prince, Inc.
|Cash | |250 | |
| |Interest Expense | |250 |
To record net cash received from Meno Bank;
$250 = [(.065 - .064) X $1,000,000]/4.
|Investment in Swaps | |33,000 | |
| |Other Comprehensive Income | |33,000 |
To mark to market interest rate swap serving as a cash flow hedge; unrealized
gain entered in other comprehensive income.
E11.14 (cont=d.)
Meno Bank
|Cash | |500 | |
| |Gain on Swaps | |500 |
To record net gain on the swap from 7/1/X8 to 9/30/X8;
$500 = $750 - $250.
|Investment in Swaps | |42,000 | |
| |Gain on Swaps | |42,000 |
To mark to market the bank=s net swap position and
record the gain in earnings.
E11.15 INTEREST RATE SWAP: JOURNAL ENTRIES
Requirement 1:
January 1, 20X0
|Cash | |10,000,000 | |
| |Note Payable | |10,000,000 |
To record issue of a note payable for cash.
(The interest rate swap has no value at inception.)
June 30, 20X0
|Interest Expense | |450,000 | |
| |Cash | |450,000 |
To record interest for the first six months;
$450,000 = .09 X $10,000,000/2.
|Cash | |35,000 | |
| |Interest Expense | |35,000 |
To record net cash payment from counterparty to swap;
$35,000 = (.09 - .083) X $10,000,000/2; .083 = .077
(average LIBOR) + 60 bp.
E11.15 (cont=d.)
|Investment in Swaps | |275,000 | |
| |Gain on Hedge Activity | |275,000 |
To record the change in fair value of the swap as an asset
(decline in market interest rate increases the present value
of the 9% fixed payments received from counterparty.
|Loss on Hedge Activity | |275,000 | |
| |Note Payable | |275,000 |
To mark the hedged debt to market.
Requirement 2:
The swap in 1. is a fair value hedge (receive fixed/pay variable) and value changes are reported in earnings. In 2., however, Marshall is hedging the variable interest payments on its variable rate debt and has a cash flow hedge (receive variable/pay fixed). Value changes on cash flow hedges are reported in other comprehensive income. Moreover, the present value of Marshall=s fixed payment obligation rises when interest rates fall so that Marshall=s new swap becomes a liability, not an asset.
In sum, Marshall recognizes a liability for the swap and the related loss is entered in other comprehensive income.
SOLUTIONS TO PROBLEMS
P11.1 COMMODITY FUTURES (SHORT) ENTRIES, GAIN/LOSS CALCULATIONS
Requirement 1:
August 1, 20X5
|Investment in Futures | |75,000 | |
| |Cash | |75,000 |
To record the initial margin deposit of $75,000 paid to the broker.
September 30, 20X5
On September 30, Davis has realized a loss of $40,000 [= (10,000 ($167 - $163)] as the cost of closing out the short position has increased. The loss is realized because additional cash must be deposited with the broker and the entry is as follows:
|Loss on Hedge Activity | |40,000 | |
| |Cash (or Investment in Futures) | | |
| | | |40,000 |
To record the additional margin deposit due to the price
movement adverse to a short position. Because this is a
fair value hedge, the loss is recognized currently in income.
|Inventory (Soybean Meal) | |40,000 | |
| |Gain on Hedge Activity | |40,000 |
To recognize the value change in the inventory.
October 28, 20X5
When Davis closes out the short position on October 28, it recoups its earlier loss of $40,000 and nets a gain of $2 (= $163 - $161) per ton, or $20,000. The entries to record closing out the short position appear below. Cash received from the broker includes the $75,000 margin deposit made on August 1.
P11.1 (cont=d.)
|Investment in Futures | |60,000 | |
| |Gain on Hedge Activity | |60,000 |
To record the gain on the short futures position caused by
the decline in the futures price; $60,000 = ($161 - $167) X 10,000.
|Loss on Hedge Activity | |60,000 | |
| |Inventory (Soybean Meal) | |60,000 |
To recognize the value change in the inventory.
|Cash | |135,000 | |
| |Investment in Futures | |135,000 |
To record closing the short position and settling with the broker.
The broker returned cash of $135,000 (= $75,000 + $60,000).
NOTE: If the $40,000 to cover the loss on September 30 was credited to Investment in Futures, the cash returned and the balance in Investment in Futures is only $95,000 (= $75,000 - $40,000 + $60,000).
Requirement 2:
When Davis sells the soybean meal in the spot market, it realizes a gain of $405,000 {= [$148.50 - ($110 + $4 - $6)] x 10,000}. This gain may be analyzed as follows.
|Gain on sale, ignoring the hedge [10,000 ($148.50 - $110)] |$385,000 |
|Net gain on the hedge [10,000 ($6 - $4)] |20,000 |
|Net Gain |$405,000 |
P11.1 (cont=d.)
OR
|Gain on sale assuming delivery pursuant to futures contract [($163 - $110) X 10,000] | |
| |$530,000 |
|Gain on futures contract [($163 - $161) X 10,000] |20,000 |
|Loss resulting from decision to sell on the spot market instead of delivering under the futures contract | |
|[($163.00 - $148.50) X 10,000] | |
| |(145,000) |
|Net Gain |$405,000 |
Requirement 3:
Had Davis purchased (rather than sold) the futures for $163, later closing out this position by selling futures for $161, a $20,000 [= ($161 - $163) X 10,000] net cash loss is sustained.
Because Davis already owns the soybean meal inventory, and does not have a firm commitment to fulfill, purchase of soybean meal futures is either speculative or, if the futures purchase is hedging an anticipated transaction, a cash flow hedge. The accounting treatments of the short gain and the long loss are described next.
Short Gain: Because the sale of futures qualifies as a fair value hedge in this problem, the net $20,000 short gain in 1. enters earnings but is offset by the value change in the hedged inventory.
Long Loss: If the purchase of futures is speculative, the $20,000 net loss on the futures is recognized in earnings when realized. But if the futures purchase qualifies as a cash flow hedge, the $20,000 net loss is first accumulated in other comprehensive income and later released to earnings when the hedged anticipated transaction impacts earnings.
P11.2 INTEREST RATE FUTURES ENTRIES AND ANALYSIS
Requirement 1:
The long position in Treasury bill futures hedges the anticipated roll-over of Greenstein's short-term Treasury bill investments, serving as a cash flow hedge. On June 30, Greenstein realizes a gain of $2,500 [= (.91 - .90) $1,000,000/4], entering it in other comprehensive income pending completion of the roll-over. A further gain of $1,250 [= (.915 -.91) $1,000,000/4], realized on August 30, enters other comprehensive income. The $3,750 total is reclassified from other comprehensive income to earnings over time after the new bills are purchased. It has the same effect as a discount that reduces the cost of the new Treasury bills and is subsequently amortized to income as part of interest revenue.
June 1
|Investment in Futures | |10,000 | |
| |Cash | |10,000 |
To record the initial $10,000 margin deposit paid to the broker.
June 30
|Investment in Futures | |2,500 | |
| |Other Comprehensive Income | |2,500 |
To mark the Treasury bill futures to market and enter the
resulting gain in other comprehensive income.
August 30
|Investment in Futures | |1,250 | |
| |Other Comprehensive Income | |1,250 |
To mark the Treasury bill futures to market and enter the
resulting gain in other comprehensive income.
P11.2 (cont=d.)
|Cash | |21,250* | |
|Investment in Treasury Bills (new) | | | |
| | |978,750 | |
| |Investment in Treasury Bills (old) | |1,000,000 |
To record the roll-over of the investment in the Treasury bills.
|Cash | |13,750 | |
| |Investment in Futures | |13,750 |
To record receipt of the margin deposit from the broker
($13,750 = $10,000 + $2,500 + $1,250).
As interest revenue on the new Treasury bills is recorded, it will be augmented by a pro-rata share of the $3,750 gain released from other comprehensive income.
|*Cash received from redemption of old securities |$1,000,000 |
| Cost of new securities: $1,000,000 -[$1,000,000 X (.085/4)] | (978,750) |
| Net cash received |$ 21,250 |
Requirement 2:
The cost of the new Treasury bills is $978,750, which reflects the current 8.5% annual discount yield (2.125% quarterly).
$978,750 = $1,000,000 - ($1,000,000 X .02125)
However, the $3,750 cash gain on the futures contracts currently in other comprehensive income will increase interest income by $3,750 over the 91-day term of the new Treasury bills. Thus the total return on the new Treasury bills is $25,000 (= $21,250 + $3,750), which reflects a 10% annual discount yield (2.5% quarterly); $25,000 = .025 X $1,000,000.
P11.3 INTEREST RATE FUTURES: FAIR VALUE HEDGE
Requirement 1:
At 90, each $1,000 bond has a value of $900 and futures contracts for 1,000 bonds [= (300,000 X $3)/900)] would be sold to protect the value of Petren's own bonds that ultimately will be sold to pay for the fabric. The face value of these bonds is $1,000,000 (= 1,000 X $1,000). This sale of futures at 90 produces a realized loss of ($20,000) [= (.90 - .92) X $1,000,000] when the futures contract is closed out (by purchasing futures at 92). The $20,000 loss offsets the $20,000 [= (.92 - .90) X $1,000,000] realized gain on Petren's bonds due to their increase in value before being sold to pay for the fabric. Petren could report both the $20,000 gain and offsetting $20,000 loss but will likely net them out. Thus the net result of this hedge is no gain or loss and no effect on earnings.
Notes to Instructor:
(1) Some students may believe that other comprehensive income should come into play here. Whereas unrealized value changes in available-for-sale (AFS) securities are normally accumulated in other comprehensive income per SFAS 115, when AFS securities are hedged by a derivative, SFAS 133 requires that the AFS value change be reported in earnings to offset the derivative=s value change. A careful reading of Requirement 1 indicates that the value changes are realized. The value changes in Requirement 2, though, are unrealized.
(2) Some students may interpret this as a cash flow hedge of the anticipated sale of the bonds, an interpretation that is consistent with SFAS 133, and raise the prospect of other comprehensive income in this context. However, the intent of this problem is that the futures are hedging the fair value of the bonds held, not the forecast sale of the bonds. Paragraph 411 (a) of SFAS 133 indicates that an entity could designate the futures as either a fair value hedge of the bonds= value or a cash flow hedge of the uncertain cash flow from anticipated sale of the bonds.
P11.3 (cont=d)
Requirement 2:
At any intervening balance sheet date, the futures are revalued to fair value along with the AFS bonds, the hedged item. An unrealized loss is recognized on the short futures as it now costs 91.5 to enter an offsetting long contract to settle the short contract sold at 90. This loss is offset by an unrealized gain on the bonds which increased in value from 90 to 91.5. Both loss and gain are recognized in earnings.
|Loss on Hedge Activity | |15,000 | |
| |Investment in Futures | |15,000 |
To record unrealized loss on futures serving as a fair value
hedge; ($15,000) = (.90 - .915) X $1,000,000.
|Investment in AFS Bonds | |15,000 | |
| |Gain on Hedge Activity | |15,000 |
To record unrealized gain on AFS bonds;
$15,000 = (.915 - .90) X $1,000,000.
Requirement 3:
To hedge the value of its AFS bonds, Petren has to sell Treasury bond futures. If Petren buys Treasury bond futures, it no longer has an exposure to hedge and now has a speculative futures investment. Thus the purchase of futures described in the problem does not qualify as a hedge.
Requirement 4:
Here futures are purchased at 90. If sold at 93, the futures produce a realized gain of $30,000 [= (.93 -.90) X $1,000,000]. The bonds sold from Petren's own portfolio also produce a gain of $30,000 for a total gain of $60,000 that is recognized in current earnings.
P11.4 EVALUATING HEDGING WITH FUTURES CONTRACTS
Requirement 1:
Advantages of hedging with futures contracts include:
1. fixing the sale price of the commodity at the futures price ($4.75 in this case) when the contract is entered.
2. eliminating the possibility of loss.
Disadvantages of hedging with futures contracts include:
3. tying up capital ($200,000 in this case) in a non-interest bearing margin deposit.
4. eliminating the possibility of gain.
Requirement 2:
If the commodities are hedged with futures contracts, 1,000,000 bushels will be worth $4,750,000 when harvested in six months. However, interest of $8,000 (= .5 X .08 X 200,000) on the margin deposit is foregone. Thus in six months the net proceeds from, or value of, the commodities is $4,742,000 (= $4,750,000 - $8,000), implying that $4.742 per bushel is the price at which the company is indifferent.
At a spot price below $4.742, hedging dominates not hedging. If the price exceeds $4.742, not hedging dominates.
P11.4 (cont=d.)
Requirement 3:
Financial Statement Effects Dr. (Cr.)
| |(1) |(2) |(3)=(1)-(2) |
| | |Hedge with | |
| |No Hedge |Futures Contracts |Difference |
|Cash |$ 8,000 |$ (500,000) (1) |$ 508,000 |
|Inventory |5,250,000 (2) |5,250,000 (2) |C |
|Gain on Growing Crops | | | |
| |(5,250,000) |(5,250,000) |C |
|Loss on Futures Contracts | | | |
| |C |500,000 (1) |(500,000) |
|Interest Income |(8,000) |C |(8,000) |
(1) Reflects $500,000 [= (4.75 - 5.25)1,000,000] loss on futures contracts.
(2) Carried at market; $5.25 X 1,000,000.
P11.5 EVALUATING HEDGING WITH OPTION CONTRACTS
Requirement 1:
Advantages of hedging with option contracts include:
5. eliminating the possibility of loss--a decline in the commodity's price will, in the case of put options, be offset by a gain on the option.
6. not negating any gain created by an increase in the commodity's price.
The principal disadvantage of hedging with option contracts is paying the nonrefundable premium ($350,000 in this case).
P11.5 (cont=d.)
Requirement 2:
If the commodities are hedged with option contracts and the options are exercised or in the money at expiration, 1,000,000 bushels will be worth a net of $4,650,000 [= ($5 X 1,000,000) - $350,000]. Thus at a $4.65 spot price the company is indifferent. For spot prices below $4.65, hedging dominates not hedging. For spot prices above $4.65, not hedging dominates hedging.
Lost interest is ignored in the options case because the $350,000 cash paid for the options is gone permanently; $350,000 is the present value of interest and principal repayment foregone. In the futures case, the margin deposit caused temporary nonuse of the cash--the cash received when the margin deposit is returned has a lower present value than the cash originally deposited. The lost interest approximates this reduction in present value.
Requirement 3:
Financial Statement Differences Dr. (Cr.)
| |(1) |(2) |(3)=(1)-(2) |
| | |Hedge with | |
| |No Hedge |Option Contracts |Difference |
|Cash |C |$ (100,000) (1) |$100,000 |
|Inventory |4,750,000 (2) |4,750,000 (2) |C |
|Gain on Growing Crops | | | |
|Gain on Growing Crops |(4750,000) |(4,750,000) |C |
|Net Loss on Options |C |100,000 (1) |(100,000) |
(1) ($100,000) = $250,000 [= ($5.00 - $4.75) X 1,000,000] cash gain on puts - $350,000 premium.
(2) Carried at market; $4.75 X 1,000,000.
P11.6 SHORT ANSWER: CURRENCY OPTIONS
Requirement 1:
The strategy of purchasing call options on pounds can be understood by referring to to Panels D, E and F of Figure 11.2. Panel E is the exposed liability--the dollar cost of supplying pounds--with the rising dollar cost of pounds to the right of the origin. The Panel E exposure can be hedged by purchasing call options to buy pounds for dollars.
The strategy of purchasing put options on dollars can be understood by referring to Panels A, B and C of Figure 11.2. One way of getting the British pounds needed is to sell dollars for pounds. Here our stock of dollars, an asset, represents the exposure. A decline in the pound price of dollars occurs when the dollar depreciates--to the left of the origin in Panel B--and can be hedged by purchasing put options to sell dollars for pounds (Panel B). (NOTE: a decline in the pound price of dollars is equivalent to Athe rising dollar cost of pounds@ as expressed above.)
Requirement 2:
Again the dollar cost of purchasing pounds is the exposure (Panel E in Figure 11.2). The strategy of buying calls and writing puts on pounds with the same exercise price creates a synthetic long futures contract which hedges the exposure as shown in Panels D, E and F of Figure 11.3. The net premium paid (received) is the cost (benefit) from adopting this strategy as opposed to simply purchasing futures (Panel A in Figure 11.1)
Requirement 3:
Despite the way the problem is worded, the U. S. construction company=s exposure is denominated in euros and is shown in Panel E of Figure 11.2. Thus the hedge will be accomplished by purchasing call options to buy euros as shown in Panel D. Then if the dollar cost of euros rises (to the right of the origin), the calls go in the money and the gain in Panel D offsets the loss in Panel E, an effective hedge.
P11.6 (cont=d.)
Requirement 4:
The bank wishes to protect the dollar equivalent of the euro-denominated interest, the exposure depicted in Panel B of Figure 11.2. If a call to purchase euros with dollars is written (Panel D of Figure 11.2) and the dollar strengthens (to the left of the origin), the call is out of the money and expires unexercised. The premium received, however, increases the bank's net return. If the dollar weakens, the gain on the euro-denominated interest (to the right of the origin in Panel B) will be offset by the loss on the written call (to the right of the origin in Panel D).
Another strategy is to purchase puts to sell pounds for dollars (Panel A of Figure 11.2). If the dollar strengthens, the put goes in the money and the gain thereon offsets the loss incurred when converting the interest back into dollars.
Requirement 5:
By not hedging, the U.S. company loses $.02 (= $1.45 - $1.43) per euro. With the calls, the $.02 gain on each call negates the $.02 transaction loss on the interest. However, the $.03125 premium paid is all time value which, assuming the calls expire when the interest is due, is a loss that increases the company's financing cost by more than the $.02 loss from not hedging.
P11.7 PRESENT VALUE ANALYSIS OF INTEREST RATE CAP
Requirement 1:
This is a straight capital budgeting problem in which the $400,000 outlay for the cap is compared with the present value of the interest savings under the assumed prime rates. Savings begin on July 1, 20X7 [$100,000 = (.10 - .09) X $10,000,000] and increase in each of the two years beginning on July 1, 20X8 [$300,000 = (.12 - .09) X 10,000,000]. These savings are realized at the end of each fiscal year when the interest is due and the bank settles up.
PV of savings = $100,000/(1.10)2 + $300,000/(1.12)3 +
$300,000/(1.12)4
= $82,645 + $213,534 + $190,655
= $486,834
Since $486,834 > $400,000, purchase of the cap is a good economic decision if the prime rate increases as expected.
Requirement 2:
A similar approach is used here except that savings are based on comparing the new lower 6% prime rate with the original 8% [$200,000 = (.08 - .06) X 10,000,000].
PV of savings = $200,000/(1.06)2 + $200,000/(1.06)3 +
$200,000/(1.06)4
= $177,999 + $167,924 + $158,419
= $504,342
Since $504,342 > $400,000, the projected interest savings more than offset the cost of the cap. Given the assumptions in Requirements 1 and 2, the cap hedges the potential loss from higher interest rates and the potential savings from lower interest rates hedge the cost of the cap.
P11.7 (cont=d.)
Requirement 3:
December 31, 20X7
|Interest Expense | |500,000 | |
| |Interest Payable | |500,000 |
To record interest on the loan accrued since 6/30/X7;
$500,000 = (.10 X $10,000,000)/2.
|Investment in Interest Rate Cap | |50,000 | |
| |Interest Expense | |50,000 |
To record the gain on the cap and reduce interest expense
accordingly; $50,000 = [(.10 - .09) X 10,000,000]/2.
|Loss on Options | |50,000 | |
| |Investment in Interest Rate Cap | |50,000 |
To recognize the decline in fair value of the total $400,000
time value premium for four years at the rate of $50,000 (1/8)
per six-month period.
Alternate Entry
|Loss on Options | |50,000 | |
| |Interest Expense | |50,000 |
June 30, 20X8
|Interest Expense | |500,000 | |
| |Interest Payable | |500,000 |
To record interest on the loan accrued since 12/31/X7.
|Interest Payable | |1,000,000 | |
| |Cash | |1,000,000 |
To pay interest accrued since 6/30/X7.
P11.7 (cont=d.)
|Investment in Interest Rate Cap | |50,000 | |
| |Interest Expense | |50,000 |
To reduce the gain on the cap and reduce interest expense accordingly.
|Cash | |100,000 | |
| |Investment in Interest Rate Cap | |100,000 |
To record collection of one year's excess interest due under
the interest rate cap.
|Loss on Options | |50,000 | |
| |Investment in Interest Rate Cap | |50,000 |
To recognize the decline in fair value of the total $400,000
time value premium for four years at the rate of $50,000 (1/8)
per six-month period.
P11.8 HEDGING EXPOSED ASSETS WITH PUT OPTIONS
Requirement 1:
November 1, 20X5
|Other Comprehensive Income | | | |
| | |20,000 | |
| |Short-Term Investments | |20,000 |
To revalue the short-term investments to market value;
the decline in value from $40 to $38 per share enters
other comprehensive income because the investments
are unhedged during this period.
|Investment in Options | |35,000 | |
| |Cash | |35,000 |
To record purchase of 10,000 put options.
P11.8 (cont=d.)
Because the strike price is $40 and the shares are selling for $38, each put option is in the money by $2, a total of $20,000 (= 10,000 X $2). The time value is therefore $15,000 (= $35,000 - $20,000).
December 31, 20X5
|Investment in Options | |25,000 | |
| |Gain on Hedge Activity | |25,000 |
To mark the intrinsic value of the options to market;
$25,000 = 10,000 ($38 - $35.50).
|Loss on Hedge Activity | |25,000 | |
| |Short-Term Investments | |25,000 |
To mark the hedged securities to market. Note: Students
may also recognize the 11/1/X5 pre-hedge revaluation here.
|Loss on Options | |10,000 | |
| |Investment in Options | |10,000 |
To recognize assumed 2/3 (= 60/90) reduction in fair
value of the original $15,000 time value.
NOTE: As the price of the optioned item declines below the strike price, puts go further into the money and their intrinsic value increases.
Requirement 2:
|Proceeds from sale of securities (10,000 X $32) |$320,000 |
|Proceeds from sale of put options [10,000 ($40 - $32)] | 80,000 |
|Total proceeds |$400,000 |
|Cost of securities |$400,000 |
|Cost of put options | 35,000 |
|Total cost |$435,000 |
|Net cash loss |$ (35,000) |
NOTE: Because the options are sold on their expiration date, their premium no longer includes any time value and the proceeds consist only of intrinsic value.
P11.8 (cont=d.)
Requirement 3:
20X5: The intrinsic value of the put options serves as a hedge of AFS securities carried at market and changes in the puts' intrinsic value are recognized in income. Because value changes of hedged AFS securities are also recognized in income under SFAS 133, the value changes in the options= intrinsic value and the AFS securities offset and have no net effect; 20X5 income is reduced only by the assumed $10,000 decrease in the fair value of the time value component.
20X6: Once the securities and options are sold, all unrealized gains and losses accumulated in other comprehensive income during unhedged periods are released to earnings. Requirement 1 indicates a net unrealized loss of $20,000 in other comprehensive income. This loss is now realized and, coupled with the $5,000 remaining time value that is zero at expiration, 20X6 income is reduced by $25,000.
P11.9 STRADDLE: JOURNAL ENTRIES AND PROFIT CALCULATION
Requirement 1:
January 31, 20X4
|Cash | |25,500 | |
| |Options Written (Calls) | |10,000 |
| |Options Written (Puts) | |15,500 |
To record straddle written on 5,000 shares of Montclair
Corp. stock when puts sold for $3.10 and calls for $2.
February 28, 20X4
|Options Written (Calls) | |10,000 | |
|Loss on Options | |11,000 | |
| |Cash | |21,000 |
To record closing out calls written by purchasing 5,000
calls for $4.20 each, a total of $21,000.
P11.9 (cont=d.)
|Options Written (Puts) | |11,500 | |
| |Gain on Options | |11,500 |
To mark the outstanding written puts to market and
recognize the unrealized gain (the cost to close out the
puts and remove the related obligation has fallen);
$11,500 = ($3.10 - $.80) X 5,000.
March 31, 20X4
|Options Written (Puts) | |4,000 | |
| |Gain on Options | |4,000 |
To recognize expiration of the puts and the remaining
premium as income; $4,000 = $15,500 original premium
- $11,500 gain recognized on February 28.
Requirement 2:
Suavo made $4,500 on the straddle; $25,500 in premiums were received when the straddle was written and $21,000 was paid when the calls were closed out.
P11.10 ECONOMICS OF INTEREST RATE SWAPS
Requirement 1:
| |Fixed Rate |Floating Rate |
|Axle Co.* | 9.0% |LIBOR + 90bp |
|Boda Co.** |8.7% |LIBOR + 130bp |
|Differential |.3% |(40bp) |
Here B has the advantage in fixed rate financing whereas A has the advantage in floating rate financing. This is the classic swap illustration: A takes B's lower floating rate financing and becomes the floating rate payer. Negotiation is not needed here as it is in Requirements 2 and 3.
Requirement 2:
| |Fixed Rate |Floating Rate |
|Cino Co.* | 8.0% |LIBOR + 30bp |
|Dana** |8.2% |LIBOR + 80bp |
|Differential |(.2%) |(50bp) |
Here C has the advantage in both fixed and variable financing. Because C has the greater advantage in floating rate financing, it can "afford" to swap the much lower floating financing in exchange for D's slightly higher fixed rate financing. However, to induce C to do so, D must increase the rate paid to C by, say, 30bp. If so, C winds up being the fixed rate payer at 7.9% (= 8.2% - 30bp) and D is the floating rate payer at LIBOR + 60bp (= 30bp + 30bp). This is exactly like the situation illustrated in the problem.
P11.10 (cont=d.)
Requirement 3:
| |Fixed Rate |Floating Rate |
|Eske Co.*** | 9.5% |LIBOR + 40bp |
|Fox Co.*** |9.3% |LIBOR + 20bp |
|Differential | .2% |20bp |
Because neither party has an absolute or relative advantage in fixed or floating rate financing, there is no basis for an exchange beneficial to both parties.
Requirement 4:
| |Fixed Rate |Floating Rate |
|Gary Co.* | 7.8% |LIBOR + 70bp |
|Hawk Co.** |7.3% |LIBOR + 30bp |
|Differential |.5% |40bp |
Here H has the advantage in both fixed and floating rate financing. Although there is little room for negotiation, H will swap its fixed rate financing for G's floating rate financing. H will pay an additional amount, say 45bp, to G. In sum, G becomes the fixed rate payer at 7.75% (= 7.3% + 45bp) and H becomes the floating rate payer at LIBOR + 25bp (= 70bp - 45bp).
* Fixed rate payer
** Floating rate payer
*** No swap occurs as neither party has a relative advantage.
P11.11 EVALUATE STRATEGIES TO HEDGE AGAINST RISING INTEREST RATES
Requirement 1:
The swap converts the variable LIBOR + 80 bp rate to a fixed 7% rate. If LIBOR stays at 6%, Guerard will pay 20 extra basis points in interest each year under the swap, a total of $400,000 (=.002 x $100,000,000 x 2). In these circumstances payment of $400,000 for the 7% cap, which will not go in the money, should make Guerard indifferent between the swap and the cap.
Requirement 2:
If LIBOR is allowed to vary, the problem is much more complicated and in some sense depends on Guerard=s ability to predict movements in LIBOR better than its potential counterparties. If LIBOR rises above 6.2%, the swap protects Guerard at no cost, whereas the cap provides the protection at a cost. But if LIBOR falls, Guerard is exposed to considerable variable opportunity losses under the swap whereas the cap=s cost is fixed and there is no return from it. In general, risk aversion seems to favor the cap that has a fixed known cost. Greater tolerance for risk favors the swap as long as increases in LIBOR are likely and the opportunity losses incurred when LIBOR falls are viewed as real cash payments.
Requirement 3:
If the futures are to hedge against rising interest rates, they should be sold. If Guerard sells futures at 93 and the discount yield rises to 10%, meaning more interest payments on Guerard=s variable debt, being able to buy back the futures at 90 and realize the 3-point gain will offset the higher interest payments.
P11.11 (cont=d.)
Of course, futures are double-edged swords and require performance whether conditions are favorable or not. Thus if interest rates go down, and interest payments on the debt fall, those opportunity gains are wiped out by the losses incurred to cover the short futures position when repurchasing at a higher cost. Of the three alternativesCswap, options (interest rate cap) and futuresConly the options retain the opportunity for gain, but at a known fixed cost. If Guerard seeks to minimize risk then it must consider the terms and cost of available caps offered by counterparties in the light of its own assessment of future interest rate movements.
P11.12 INTEREST RATE SWAP: ENTRIES AND MARK TO MARKET
Requirement 1:
The rise in LIBOR to 8.3% means that Johnson's variable interest rate is 9.5% (8.3% + 120bp). As part of its normal bookkeeping process, Johnson accrues $237,500 [= (.095 X $10,000,000)/4] of interest expense on its floating rate debt. Under the swap, Johnson receives the $237,500 floating interest from the intermediary while paying $225,000 [= (.09 X 10,000,000)/4] fixed to the intermediary. The entry to record the $12,500 (= $237,500 - $225,000) net payment from intermediary follows.
|Cash | |12,500 | |
| |Interest Expense | |12,500 |
To record net payment from intermediary under the swap,
adjusting interest expense to $225,000.
Note to Instructor: Students may also have shown Johnson's entry to record the $237,500 of interest expense.
P11.12 (cont=d.)
Requirement 2:
With LIBOR rising by .5%, the fixed rate is assumed to also rise by .5% to .095 or .02375/quarter.
We now discount the fixed side of the swap as follows:
Interest: $1,244,525 = 225,000/1.02375 + 225,000/(1.02375)2 + 225,000/(1.02375)3 + 225,000/(1.02375)4
+ 225,000/(1.02375)5 + 225,000/(1.02375)6
= 219,780 + 214,682 + 209,701 + 204,836
+ 200,084 + 195,442
Principal: 8,686,334 = 10,000,000/(1.02375)6
$9,930,859
Thus, the fixed side of the swap (liability) decreases in fair value by $69,141 (= $10,000,000 - $9,930,859). Equivalently, $69,141 equals the present value of the six-period ordinary annuity of $12,500 (= $237,500 - $225,000) discounted at 2.375% per period. This unrealized gain is recorded as follows:
|Investment in Swaps | |69,141 | |
| |Gain on Hedge Activity | |69,141 |
To mark the swap to market, recognizing that it has gone
"in the money" by providing net payments from intermediary.
NOTE: There would also be an offsetting entry to mark the hedged investments to market.
P11.12 (cont=d.)
Requirement 3:
Assuming that the $65,000 value change created by the .5% rise in interest rates relates to both the swap and the fixed rate investments, the carrying value of both is adjusted by that amount.
|Investment in Swaps | |65,000 | |
| |Gain on Hedge Activity | |65,000 |
To mark the swap to market, indicating the decrease in
present value of the expected net payments to intermediary.
|Loss on Hedge Activity | |65,000 | |
| |Investments (Fixed-Rate) | |65,000 |
To mark the fixed rate investments to market, indicating
the decrease in present value of the investments' fixed receipts.
Requirement 4:
|Investment in Swaps | |65,000 | |
| |Other Comprehensive Income | | 65,000 |
To mark the swap to market, reporting the value change
of this cash flow hedge in other comprehensive income.
P11.13 CRITIQUE PROPOSED CURRENCY/INTEREST RATE SWAP ARRANGEMENT
Requirement 1:
About the best that can be said is that the proposed swap is backwards, for the following reasons.
1. Reno is borrowing ,10,000,000 but it needs dollars now and pounds in three years when the ,10,000,000 is due.
2. SB is borrowing $16,000,000 but it needs pounds now and dollars in three years when the $16,000,000 is due.
3. On each intervening June 24, Reno needs pounds, not dollars, to pay the , interest on the ,10,000,000 loan.
The parties must have intended the following, the opposite of the arrangements described in the problem.
4. On 6/24/X6, Reno is to swap the ,10,000,000 loan proceeds to SB for $16,000,000 to be used in the U.S. SB swaps its $16,000,000 loan proceeds for ,10,000,000 to be used in the U.K.
5. On 6/24/X9, Reno is to swap $16,000,000 to SB for ,10,000,000 to repay the pound-denominated loan. And SB gets the $16,000,000 it needs to repay the dollar-denominated loan.
6. Regarding the interest due on the three June 24 dates, SB should pay Reno enough pounds to cover Reno's floating pound interest in exchange for $1,440,000 for SB's fixed dollar interest.
P11.13 (cont=d.)
Requirement 2:
For the year ended June 24, 20X9:
| |Foreign Currency Needed by | | |
| |Reno | | |
| | |Dollars Paid |Exchange |
| | |By Reno |Rate |
|Swaps (items 4-6 above) |,11,080,000 (1) |$17,440,000 (2) |1.574/, (4) |
|No swaps |11,080,000 (1) | 16,620,000 (3) |1.500/, |
|Dollars saved w/o swaps | |$ 820,000 | |
(1) ,11,080,000 = ,10,000,000 principal + ,1,080,000 (= .108 X ,10,000,000) interest.
(2) $17,440,000 = $16,000,000 principal + $1,440,000 interest.
(3) $16,620,000 = $1.5 X ,11,080,000.
(4) $1.574/, = $17,440,000/,11,080,000
Thus without the swaps in 20X9, Reno could have acquired the ,11,080,000 needed for $16,620,000 because the dollar strengthened and the exchange rate dropped to $1.50/,, and would have realized a savings of $820,000.
P11.14 COMPREHENSIVE DERIVATIVES AND SFAS 133
Requirement 1:
Most students will cite: Financial statement recognition of derivatives, fair value as the valuation basis, and the availability of hedge accounting provisions. Other important provisions include: consistent accounting for all derivatives, creative approach to hedging, including recognizing firm commitments and using other comprehensive income, and emphasis on measuring hedge effectiveness.
P11.14 (cont=d.)
Requirement 2:
Students that look carefully at how the various derivatives operate, including institutional arrangements, should identify futures contracts as the derivatives least likely to be incrementally affected by SFAS 133's accounting rules. Economic events relating to futures tend to be accompanied by cash flowsCinitial margin requirement and daily cash settlement with the futures exchange as value moves up and downCwhich, as realized transactions, are accounted for naturally. SFAS 133 clearly affects the accounting treatment of the value changes, but not their recognition. Prior practice, whatever its specific accounting rules, did account for cash inflows and outflows.
Options probably rank next as cash is paid to purchase an option but value changes are unrealized and not likely to be naturally recognized. Interest rate swaps were (are?) not well understood and it is hard to imagine anything other than periodic cash settlement payments between counterparties and intermediaries being recognized.
NOTE TO INSTRUCTOR: Some students will observe that intermediaries and other market-makers or traders in these derivatives would have recognized the derivatives at fair value, including value changes, so that SFAS 133 likely has much less of an effect on these entities than on the end-users.
Requirement 3:
When used for speculation, SFAS 133 requires full recognition of derivatives= value changes in earnings. In Anormal markets@ one expects modest price changes, both up and down; even interest rates should not fluctuate greatly. We believe, however, that the three derivative types affect earnings in the following order: interest rate swaps (greatest), futures contracts, and options (least). Our reasons are: (1) any change in interest rates affects the present value of the entire stream of payments remaining in the swap and should produce the greatest earnings effects; (2) options that are out of the money are
P11.14 (cont=d.)
likely to have minimal value changes and, because of their one-sided nature, periodic earnings effects should be less than (3) futures contracts which have two sides to be affected but do not likely involve streams of future payments to be affected as do interest rate swaps.
NOTE TO INSTRUCTOR: The above answer to this speculative problem is itself speculative since no numbers are given. Counterexamples to that answer certainly exist so there probably is no right or wrong ranking. Of greater importance is the quality of the student=s explanation.
Requirement 4:
Forwards are advantageous when the arrangement must be tailor-made or the item needed is not traded on a futures market, delivery from/to the counterparty is actually contemplated, deferred cash settlement is desired, and minimal risk of nonperformance exists.
Futures are advantageous when standardized amounts of items traded are sufficient, delivery is contemplated at a cash market and not through the exchange, flexibility and liquid markets are important, immediate periodic cash settlements are acceptable, and nonperformance risk of alternatives is high. Organized futures markets are likely to be more efficient than informal forward markets and, if they can be used, will probably produce the same hedging benefits as forwards at lower cost.
Options are advantageous when retaining the opportunity for gain is important and the cost palatable, and deferred cash settlement is desired. Dealing with options traded on organized exchanges is likely to be more efficient than dealing with informal options traders.
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