Find more at www.downloadslide.com CHAPTER SOLUTIONS TO MULTIPLE CHOICE QUESTIONS, EXERCISES AND PROBLEMS MULTIPLE CHOICE QUESTIONS a $905,000 = $1,000,000 – ($1,340,000 – $1,245,000) d $90,000 = $1,400,000 – $1,310,000; asset because prices declined on a short position c Sales revenue Cost of sales $1,000,000 – ($1,340,000 - $1,200,000) Gross margin $1,290,000 860,000 $ 430,000 b Call options lock in the future purchase price; they cannot hedge inventory already purchased Put options hedge existing inventories by locking in their selling price a (.05 - 047) x ½ x $4,000,000 = $6,000 c Interest expense reduces by $6,000 (gain) but the cap increases in value by $5,000 Therefore the time value change is a $1,000 loss The entry is: Loss on cap Investment in cap Interest expense 1,000 5,000 6,000 d $1,000 = (4.0% - 3.8%)/2 x $1,000,000 net cash received to settle the swap Solutions Manual, Chapter ©Cambridge Business Publishers, 2013 Find more at www.downloadslide.com b A receive fixed/pay variable swap is a fair value hedge of the fixed rate debt Both the debt and the swap are marked to market, with value changes reported in income Because interest rates declined, the fair value of the debt increased, creating a loss a A receive fixed/pay variable swap is a fair value hedge of the fixed rate debt Both the debt and the swap are marked to market, with value changes reported in income Because interest rates declined, Sunny pays the lower variable rate and the fair value of the swap increased, creating a gain 10 c A receive variable/pay fixed swap is a cash flow hedge of the variable rate interest payments The swap is marked to market, with value changes reported in OCI The debt is not revalued Because interest rates declined, the present value of the fixed payment obligation increased, creating a loss The loss will be reclassified to income in the next period, adding to the lower variable interest recorded on the variable rate debt ©Cambridge Business Publishers, 2013 Advanced Accounting, 2nd Edition Find more at www.downloadslide.com EXERCISES E9.1 Fair Value Hedge: Short in Commodity Futures a January 6, 2013 Investment in futures 10,000 Cash To record the initial margin deposit on the sale of commodity futures February 19, 2013 Loss on hedging 10,000 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 hedging 11,000 To adjust the carrying value of the hedged inventory for the change in 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, 2013 Cash (or accounts receivable) 173,500 Sales 173,500 To record sale of commodities Cost of goods sold Inventory To charge the inventory sold to cost of sales b 161,000 161,000 If AIPC 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 AIPC’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 Solutions Manual, Chapter ©Cambridge Business Publishers, 2013 Find more at www.downloadslide.com E9.2 Fair Value Hedge: Long in Commodity Futures a June 1, 2014 Investment in futures 10,000 Cash To record the initial margin deposit on the purchase of commodity futures 10,000 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) x 10,000] is realized on June 30, representing a gain on the futures contracts and a loss on the exposed liability June 30, 2014 Investment in futures 10,000 Gain on hedging 10,000 To record the $10,000 gain on the long position hedging deferred revenue, an existing liability Loss on hedging 10,000 Deferred revenue 10,000 To record in earnings the increase in the fair value of the commodities needed to settle the liability A further value change of $5,000 [= ($11.50 - $11) x 10,000] is realized on August 29, which also is a gain on the futures contracts and a loss on the exposed liability August 29, 2014 Investment in futures 5,000 Gain on hedging 5,000 To record the $5,000 gain on the long position hedging deferred revenue, an existing liability Loss on hedging 5,000 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 When the commodities are shipped to the customer, the deferred revenue, which now includes the total $15,000 value change (loss), will be recognized as realized revenue ©Cambridge Business Publishers, 2013 Advanced Accounting, 2nd Edition Find more at www.downloadslide.com b E9.3 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) Realized gain on futures contract [($11.50 - $10.00) x 10,000] Net cost of commodity Amount saved by hedging $115,000 (15,000) $100,000 $ 15,000 Hedge of Firm Commitment: Short in Commodity Futures The short position in the futures contract hedges a firm sale commitment and is a fair value hedge May 1, 2014 Investment in futures 10,000 Cash To record the initial margin deposit of $10,000 paid to the clearinghouse May 30, 2014 Investment in futures 10,000 20,000 Gain on hedging To mark the short futures position to market and recognize the gain in earnings; $20,000 [= ($5.00 - $4.80) x 100,000] 20,000 Loss on hedging 20,000 Firm commitment 20,000 To recognize the loss on the firm sale commitment due to a decline in selling prices Solutions Manual, Chapter ©Cambridge Business Publishers, 2013 Find more at www.downloadslide.com July 29, 2014 Investment in futures 5,000 Gain on hedging To mark the short futures position to market and recognize the resulting gain; $5,000 [= ($4.80 - $4.75) x 100,000] 5,000 Loss on hedging 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 To record purchase of the commodities August 28, 2014 Loss on hedging 460,000 2,000 Investment in futures To mark the futures contract to market; $2,000 [= $4.77 - $4.75) x 100,000] 2,000 Gain on hedging To recognize the gain on the firm sale commitment due to a price increase 2,000 Firm commitment Cash 2,000 33,000 Investment in futures 33,000 To close out the short futures position and recover from the clearinghouse the initial margin deposit; $33,000 (= $10,000 + $20,000 + $5,000 - $2,000) When the sale occurs, the firm commitment liability is closed to Sales Revenue, increasing it by $23,000 ©Cambridge Business Publishers, 2013 Advanced Accounting, 2nd Edition Find more at www.downloadslide.com E9.4 Economics of Hedging with Futures; Propriety of Hedge Accounting a 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) on each futures contract 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 futures contract Subtracting this $.50 gain from the unit cost of $6 leaves the net cost of the commodity at $5.50 per unit b In this case, McVeigh grows the commodity on its own farms, and may cover its delivery commitment with its own inventory However, GAAP requires only that the futures be designated as a hedge of the sale commitment The existing inventory is irrelevant E9.5 Interest Rate Cap July 2, 2013 Investment in interest rate cap 9,000 Cash To record premium paid on 4.1% interest rate cap payable in full immediately; $9,000 = $3,000,000 x 0.0015 x December 31, 2013 Interest expense 60,000 Interest payable To record interest payable on the loan for the first six months; $60,000 = $3,000,000 x 04 x Loss on options 9,000 60,000 2,000 Investment in interest rate cap 2,000 To recognize the decline in fair value of the time value portion of the premium; $2,000 = $9,000 - $7,000 The cap remains out of the money and still has no intrinsic value June 30, 2014 Interest expense Interest payable To record interest payable on the loan for the next six months; $64,500 = $3,000,000 x 043 x Solutions Manual, Chapter 64,500 64,500 ©Cambridge Business Publishers, 2013 Find more at www.downloadslide.com Investment in interest rate cap 3,000 Interest expense Loss on options 3,000 2,000 Investment in interest rate cap 2,000 To record the net $1,000 increase (= $8,000 - $7,000) in fair value of the interest rate cap The cap goes in the money by $3,000 [= $3,000,000 x (.043 - 041) x 5], which reduces interest expense to $61,500 (= x 041 x $3,000,000 = $64,500 - $3,000) At the same time the cap loses $2,000 of its time value; $2,000 = $1,000 - $3,000 Cash 3,000 Investment in interest rate cap 3,000 To record collection of the excess interest due under the interest rate cap agreement E9.6 Fair Value Hedge with Put Options March 1, 2014 Investment in options 6,200 Cash To record purchase of put options; $6,200 = 2,000 x $3.10 June 30, 2014 Loss on hedging 6,200 3,600 Investment in options To record the loss on options hedging an investment in government bonds; ($3,600) = 2,000 x ($1.30 - $3.10) Investment in bonds 3,600 4,000 Gain on hedging 4,000 To adjust carrying value of the bond investment; $4,000 = (1.00 - 0.98) x $200,000 December 31, 2014 Investment in options 6,000 Gain on hedging To record the gain on options; $6,000 = 2,000 x ($4.30 - $1.30) Loss on hedging 6,000 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 ©Cambridge Business Publishers, 2013 Advanced Accounting, 2nd Edition Find more at www.downloadslide.com 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 hedging 6,000 To record sale of put options; carrying amount prior to revaluation at December 31, 2014 is $2,600 (= $6,200 - $3,600) E9.7 Call Options Hedging Foreign Currency Debt July 1, 2012 Investment in options 28,000 Cash To record purchase of call options; $28,000 = 2,000,000 x $.014 December 31, 2012 Investment in options 28,000 110,000 Gain on hedging 110,000 To record gain on foreign currency call options hedging £2,000,000 note payable; $110,000 = ($.069 - 014) x 2,000,000 Loss on hedging 100,000 Loan payable To accrue loss on loan payable; $100,000 = ($1.55 - $1.50) x 2,000,000 June 30, 2013 Investment in options 100,000 102,000 Gain on hedging 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 hedging 120,000 Loan payable To accrue loss on loan payable; $120,000 = ($1.61 - $1.55) x 2,000,000 Cash 120,000 240,000 Investment in options 240,000 To record the sale of put options; $240,000 = 2,000,000 x $.12 = $28,000 + $110,000 + $102,000 Solutions Manual, Chapter ©Cambridge Business Publishers, 2013 Find more at www.downloadslide.com Alternate entry to record sale of options: Cash 240,000 Investment in options 138,000 Gain on hedging 102,000 To record sale of put options; carrying amount prior to revaluation at June 30, 2013 is $138,000 = $28,000 + $110,000 E9.8 Interest Rate Swap: Profit and Default a Intermediary’s Inflows and Outflows: Inflows: floating rate from Queen fixed rate from Prince Total inflows Outflows: fixed rate to Queen floating rate to Prince Total outflows Net interest rate spread LIBOR + 30 T + 40 T + 30 LIBOR + 20 3.6% 3.4% 7.0% 3.3% 3.5% 6.8% 0.2% With a 2% net spread, Intermediary was earning $2,000 (= 002 x $1,000,000) a year or approximately $167 a month b Intermediary receives T + 40 from Prince, the equivalent of 3.4% when T = 3%, while it is paying LIBOR + 20, the equivalent of 3.5% when LIBOR = 3.3% Thus the money Intermediary was making was derived from its arrangements with Queen, not Prince When LIBOR increases by 20 bp, the floating rate rises to 3.7% (= LIBOR of 3.3% + 0.2% + 0.2%) and Intermediary's loss on the arrangement with Prince increases to 0.3% (= 3.7% - 3.4%) After Queen's default, Intermediary is losing $3,000 a year or $250 a month; $250 = (.003 x 1,000,000)/12 E9.9 Interest Rate Swap: Journal Entries This is a plain vanilla swap Queen has a fair value hedge because it receives fixed from the bank and pays variable to Intermediary In contrast, Prince has a cash flow hedge because it receives variable from the bank and pays fixed to Intermediary September 30, 2014 Queen Corp Interest expense 750 Cash 750 To record net cash payment made to Intermediary; ($750) = [(.033 - 036) x $1,000,000]/4 ©Cambridge Business Publishers, 2013 10 Advanced Accounting, 2nd Edition Find more at www.downloadslide.com c Hedging with options (cash flow hedge) Investment in options 5,000 Cash To record purchase of call options; $5,000 = 100 x $50 5,000 Loss on options 5,000 Investment in options 5,000 To record expiration of the options (they remained out of the money) and the $5,000 speculative loss (Had the entire premium been designated as the hedge, including the $5,000 time value, $5,000 would still be written off as hedge ineffectiveness.) Purchases (inventory) 68,200 Cash To record purchase of the commodity; $68,200 = 100 x $682 68,200 d Commodity cost with futures hedge ($68,200 + $2,000 loss on futures) Commodity cost without hedging Cash loss from hedging as opposed to not hedging with futures $ 70,200 (68,200) $ 2,000 The futures contracts locked in the $710 price and lost $2,000 when the futures price dropped to $690 This offset the $2,000 economic gain produced by the lower purchase price The basis narrowed to $8 (= $690 – $682) from $10 (= $710 – $700) Commodity cost with options hedge ($68,200 + $5,000 option premium) Commodity cost without hedging Cash loss from hedging as opposed to not hedging with options $ 73,200 (68,200) $ 5,000 The option, a kind of insurance, expired without being used Thus its cost—the premium— expires as well ©Cambridge Business Publishers, 2013 14 Advanced Accounting, 2nd Edition Find more at www.downloadslide.com PROBLEMS P9.1 Commodity Futures a August 1, 2014 Investment in futures 75,000 Cash To record the initial margin deposit of $75,000 paid to the broker September 30, 2014 Loss on hedging 75,000 40,000 Cash (or Investment in futures) To record the loss on the futures contract; $40,000 = 10,000 x ($367 - $363) 40,000 Inventory (soybean meal) 40,000 Gain on hedging 40,000 To recognize the value change in the inventory; $40,000 = 10,000 x ($354 - $350) October 28, 2014 Investment in futures 60,000 Gain on hedging 60,000 To record the gain on the short futures position caused by the decline in the futures price; $60,000 = ($361 - $367) x 10,000 Loss on hedging 60,000 Inventory (soybean meal) 60,000 To recognize the value change in the inventory; $60,000 = 10,000 x ($348 - $354) Cash 135,000 Investment in futures To record closing the short position and settling with the broker; $135,000 = $75,000 + $60,000 Solutions Manual, Chapter 135,000 ©Cambridge Business Publishers, 2013 15 Find more at www.downloadslide.com b When Davis sells the soybean meal in the spot market, it realizes a gain of $105,000 {= [$348.50 - ($340 + $4 - $6)] x 10,000}, analyzed as follows Gain on sale, ignoring the hedge [10,000 x ($348.50 - $340)] Net gain on the hedge [10,000 x ($6 - $4)] Net gain OR Gain on sale assuming delivery pursuant to futures contract [($363 $340) x 10,000] Gain on futures contract [($163 - $161) x 10,000] Loss resulting from decision to sell on the spot market instead of delivering under the futures contract [($363.00 - $348.50) x 10,000] Net gain c $ 85,000 20,000 $105,000 $230,000 20,000 (145,000) $105,000 Had Davis purchased (rather than sold) the futures for $363, later closing out this position by selling futures for $361, a $20,000 [= ($361 - $363) 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 a 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 OCI and later released to earnings when the hedged anticipated transaction impacts earnings ©Cambridge Business Publishers, 2013 16 Advanced Accounting, 2nd Edition Find more at www.downloadslide.com P9.2 Interest Rate Futures a 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 $2,500 gain, entering it in OCI pending completion of the roll-over A further $1,250 gain, realized on August 30, enters OCI The $3,750 total is reclassified from OCI 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 Investment in futures 10,000 Cash To record the initial $10,000 margin deposit paid to the broker June 30 Investment in futures 10,000 2,500 Other comprehensive income To mark the Treasury bill futures to market and enter the resulting gain in OCI; $2,500 = (.97 - 96) x ($1,000,000/4) August 30 Investment in futures 2,500 1,250 Other comprehensive income To mark the Treasury bill futures to market and enter the resulting gain in OCI; $1,250 = (.975 - 97) x ($1,000,000/4) Cash Investment in treasury bills (new) 1,250 6,250* 993,750 Investment in treasury bills (old) To record the roll-over of the investment in the Treasury bills 1,000,000 *Cash received from redemption of old securities Cost of new securities: $1,000,000 -[$1,000,000 x (.025/4)] Net cash received $1,000,000 (993,750) $ 6,250 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 is augmented by a pro-rata share of the $3,750 gain released from OCI Solutions Manual, Chapter ©Cambridge Business Publishers, 2013 17 Find more at www.downloadslide.com b The cost of the new Treasury bills is $993,750, which reflects the current 2.5% annual discount yield (0.625% quarterly) However, the $3,750 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 $10,000 (= $6,250 + $3,750), which reflects a 4% annual discount yield (1% quarterly); $10,000 = 01 x $1,000,000 P9.3 Interest Rate Futures: Fair Value Hedge a 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 OCI should come into play here Whereas unrealized value changes in available-for-sale (AFS) securities are normally accumulated in OCI, when AFS securities are hedged by a derivative, hedge accounting requires that the AFS value change be reported in earnings to offset the derivative’s value change A careful reading of a indicates that the value changes are realized The value changes in b., though, are unrealized (2) Some students interpret this as a cash flow hedge of the anticipated sale of the bonds, and raise the prospect of OCI in this context However, the intent in this problem is for the futures to hedge the fair value of the bonds held, not the forecasted sale of the bonds ©Cambridge Business Publishers, 2013 18 Advanced Accounting, 2nd Edition Find more at www.downloadslide.com b 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 hedging 15,000 Investment in futures 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 15,000 Gain on hedging To record unrealized gain on AFS bonds; $15,000 = (.915 - 90) x $1,000,000 15,000 c 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 d 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 P9.4 Evaluating Hedging with Futures Contracts a Advantages of hedging with futures contracts include: fixing the sale price of the commodity at the futures price ($4.75 in this case) when the contract is entered eliminating the possibility of loss Disadvantages of hedging with futures contracts include: tying up capital ($200,000 in this case) in a non-interest bearing margin deposit eliminating the possibility of gain b 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 $4,000 (= x 04 x 200,000) on the margin deposit is foregone Thus in six months the net proceeds from, or value of, the commodities is $4,746,000 (= $4,750,000 - $4,000), implying that $4.746 per bushel is the price at which the company is indifferent At a spot price below $4.746, hedging dominates not hedging If the price exceeds $4.746, not hedging dominates Solutions Manual, Chapter ©Cambridge Business Publishers, 2013 19 Find more at www.downloadslide.com c Financial Statement Effects Dr (Cr.) (1) (2) Hedge with No Hedge Futures Contracts Cash $ 4,000 (1) $ (500,000) Inventory (2) 5,250,000 (2) 5,250,000 Gain on growing crops (5,250,000) (5,250,000) Loss on futures contracts Interest income (4,000) (1) 500,000 (3)=(1)-(2) Difference $ 504,000 0 (500,000) (4,000) (1) Reflects $500,000 [= (4.75 - 5.25) x 1,000,000] loss on futures contracts (2) Carried at market; $5.25 x 1,000,000 P9.5 Evaluating Hedging with Option Contracts a Advantages of hedging with option contracts include: 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 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) b 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 ©Cambridge Business Publishers, 2013 20 Advanced Accounting, 2nd Edition Find more at www.downloadslide.com c Financial Statement Differences [Dr (Cr)] (1) (2) Hedge with No Hedge Option Contracts Cash $ (1) $ (100,000) Inventory (2) 4,750,000 (2) 4,750,000 Gain on growing crops (4,750,000) (4,750,000) Net loss on options $ (1) $ 100,000 (3)=(1)-(2) Difference $ 100,000 0 $(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 P9.6 Currency Options: Short Answer Questions a The strategy of purchasing call options on pounds will see the option premium rise as the dollar cost of pounds increases Footlocker’s exposed liability—the dollar cost of supplying pounds—rises as the rising dollar cost of pounds rises This exposure can be hedged by purchasing call options to buy pounds for dollars, although the time value component of the premium will be a loss Another 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 and can be hedged by purchasing put options to sell dollars for pounds A decline in the pound price of dollars is equivalent to the rising dollar cost of pounds as expressed above Again the time value component of the premium will be a loss Because there is no reason to believe that the premiums on puts and calls will be identical, the economic effects of the two approaches will differ b The strategy of buying calls on pounds produces gains when the dollar cost of pounds rises and writing puts on pounds with the same exercise price produces losses when the dollar cost of pounds falls This combination creates what is called a synthetic long futures contract that hedges the exposure of purchasing pounds with dollars The net premium paid for the calls (received for the puts) is the cost (benefit) from adopting this strategy instead of just buying futures c Despite the way the problem is worded, KBR, Inc.’s exposure is denominated in euros and the hedge works by purchasing call options to buy euros Then if the dollar cost of euros rises, the calls go in the money and the gain on them offsets the loss on the exposure, creating an effective hedge Solutions Manual, Chapter ©Cambridge Business Publishers, 2013 21 Find more at www.downloadslide.com d Citibank seeks to protect the dollar equivalent of the euro-denominated interest it will be receiving If the bank writes calls for the purchase of euros with dollars and the dollar strengthens (the € weakens), the calls stay out of the money and expire unexercised If the dollar weakens, the gain on the euro-denominated interest will be offset by the loss on the written calls Here Citibank is a ―covered call writer‖—covered by the eurodenominated interest receivable—and the premium received increases the bank's net return Total premium received = 1111 x $800,000 = $88,880 If the dollar strengthens (and the euro weakens) by 7%, the dollar equivalent of the euro interest falls by $56,000 (= 07 x €800,000) Because the $88,880 premium exceeds the $56,000 exchange loss, writing the calls will increase Citibank’s return e By not hedging, IBM 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 IBM's financing cost by more than the $.02 loss from not hedging In total: Cost of calls = $.03125 x 70,000 = $2,188 Loss on increased dollar value of interest due to stronger euro incurred without the hedge = $.02 x 70,000 = $1,400 IBM is therefore $788 better off had the hedging not taken place and the hedge increased IBM’s financing cost P9.7 Present Value Analysis of Interest Rate Cap and Journal Entries a This is a 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, 2014 [$100,000 = (.06 - 05) x $10,000,000] and increase in each of the two years beginning on July 1, 2015 to $300,000 [= (.08 - 05) 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/(1.06)2 + $300,000/(1.08)3 + $300,000/(1.08)4 = $89,000 + $238,150 + $220,509 = $547,659 Since $547,659 > $400,000, purchase of the cap is a good economic decision if the prime rate increases as expected ©Cambridge Business Publishers, 2013 22 Advanced Accounting, 2nd Edition Find more at www.downloadslide.com b A similar approach is used here except that savings are based on comparing the new lower 2% prime rate with the original 4% [$200,000 = (.04 - 02) x 10,000,000] PV of savings = $200,000/(1.02)2 + $200,000/(1.02)3 + $200,000/(1.02)4 = $192,234 + $188,464 + $184,769 = $565,467 Since $565,467 > $400,000, the projected interest savings more than offset the cost of the cap Given the assumptions in a and b., the cap hedges the potential loss from higher interest rates and the potential savings from lower interest rates hedge the cost of the cap c December 31, 2014 Interest expense 300,000 Interest payable To record interest on the loan accrued since 6/30/14; $300,000 = (.06 x $10,000,000)/2 Investment in interest rate cap 50,000 Interest expense To record the gain on the cap and reduce interest expense accordingly; $50,000 = [(.06 - 05) x 10,000,000]/2 Loss on options 300,000 50,000 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 June 30, 2015 Interest expense 300,000 Interest payable To record interest on the loan accrued since 12/31/14 Interest payable 300,000 600,000 Cash To pay interest accrued since 6/30/14 600,000 Investment in interest rate cap 50,000 Interest expense To reduce the gain on the cap and reduce interest expense accordingly Solutions Manual, Chapter 50,000 ©Cambridge Business Publishers, 2013 23 Find more at www.downloadslide.com 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 P9.8 Fair Value Hedge: Put Options a November 1, 2013 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 OCI income because the investments are unhedged during this period Investment in options 35,000 Cash To record purchase of 10,000 put options 35,000 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, 2013 Investment in options 25,000 Gain on hedging 25,000 To mark the intrinsic value of the options to market; $25,000 = 10,000 x ($38 - $35.50) Loss on hedging 25,000 Short-term investments To mark the hedged securities to market Loss on options 25,000 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 ©Cambridge Business Publishers, 2013 24 Advanced Accounting, 2nd Edition Find more at www.downloadslide.com b Proceeds from sale of securities (10,000 x $32) Proceeds from sale of put options [10,000 x ($40 - $32)] Total proceeds Cost of securities Cost of put options Total cost Net cash loss c $320,000 80,000 400,000 400,000 35,000 435,000 $(35,000) 2013: 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 using hedge accounting, the value changes in the options’ intrinsic value and the AFS securities offset and have no net effect; 2013 income is reduced only by the assumed $10,000 decrease in the fair value of the time value component 2014: Once the securities and options are sold, all unrealized gains and losses accumulated in OCI during unhedged periods are released to earnings Requirement indicates a net unrealized loss of $20,000 in OCI This loss is now realized and, coupled with the $5,000 remaining time value that is zero at expiration, 2014 income is reduced by $25,000 P9.9 Speculative Straddle: Journal Entries and Profit Calculation a January 31, 2014 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, 2014 Options written (calls) Loss on options 10,000 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 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 Solutions Manual, Chapter ©Cambridge Business Publishers, 2013 25 Find more at www.downloadslide.com March 31, 2014 Options written (puts) 4,000 Gain on options 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 b 4,000 Fastbuck 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 P9.10 Evaluate Strategies to Hedge Against Rising Interest Rates a The swap converts the variable LIBOR + 80 bp rate to a fixed 4% rate If LIBOR stays at 3%, Apple 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 4% cap, which will not go in the money, should make Apple indifferent between the swap and the cap b If LIBOR is allowed to vary, the problem is much more complicated and in some sense depends on Apple’s ability to predict movements in LIBOR better than its potential counterparties If LIBOR rises above 3.2%, the swap protects Apple at no cost, whereas the cap provides the protection at a cost But if LIBOR falls, Apple is exposed to considerable variable opportunity losses under the swap whereas the cap’s cost is fixed and there is no return from it 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 c When the futures are hedging against rising interest rates, they should be sold If Apple sells futures at 96 and the discount yield rises to 7%, meaning more interest payments on Apple’s variable debt, being able to buy back the futures at 93 and realize the 3-point gain will offset the higher interest payments 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 alternatives—swap, options (interest rate cap) and futures—only the options retain the opportunity for gain, but at a known fixed cost If Apple 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 ©Cambridge Business Publishers, 2013 26 Advanced Accounting, 2nd Edition Find more at www.downloadslide.com P9.11 Interest Rate Swap: Journal Entries and Valuation a The rise in LIBOR to 3.3% means that J&J's variable interest rate is 4.5% (3.3% + 120bp) As part of its normal bookkeeping process, J&J accrues $112,500 [= (.045 x $10,000,000)/4] of interest expense on its floating rate debt Under the swap, J&J receives the $112,500 floating interest from the intermediary while paying $100,000 [= (.04 x 10,000,000)/4] fixed interest to intermediary The entry to record the $12,500 (= $112,500 - $100,000) 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 $100,000 NOTE TO INSTRUCTOR: Students may also have shown Johnson's entry to record the $112,500 of interest expense b 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 c Investment in swaps 65,000 Other comprehensive income 65,000 To mark the swap to market and report this cash flow hedge value change in OCI Solutions Manual, Chapter ©Cambridge Business Publishers, 2013 27 Find more at www.downloadslide.com P9.12 Critique Proposed Currency/Interest Rate Swap Arrangement a About the best that can be said is that the proposed swap is backwards, for the following reasons Reno is borrowing £10,000,000 but it needs dollars now and pounds in three years when the £10,000,000 is due SB is borrowing $16,000,000 but it needs pounds now and dollars in three years when the $16,000,000 is due 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 b On June 25, 2016, 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 On June 24, 2019, 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 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 $960,000 (= 6% x £10,000,000 x $1.60) for SB's fixed dollar interest For the year ended June 24, 2019: Swaps No swaps Dollars saved w/o swaps Foreign Currency Needed by Reno £10,780,000 (1) 10,780,000 (1) Dollars Paid By Reno $ 16,960,000 (2) 16,170,000 (3) $ 790,000 Exchange Rate 1.573/£ (4) 1.500/£ (1) £10,780,000 = £10,000,000 principal + £780,000 (= 078 x £10,000,000) interest (2) $16,960,000 = $16,000,000 principal + $960,000 interest (3) $16,170,000 = $1.5 x £10,780,000 (4) $1.573/£ = $16,960,000/£10,780,000 Thus without the swaps, in 2019 Reno could have acquired the £10,780,000 needed for $16,170,000 because the dollar strengthened and the exchange rate dropped to $1.50/£, and would have realized savings of $790,000 ©Cambridge Business Publishers, 2013 28 Advanced Accounting, 2nd Edition ... increasing it by $23,000 ©Cambridge Business Publishers, 2013 Advanced Accounting, 2nd Edition Find more at www.downloadslide.com E9.4 Economics of Hedging with Futures; Propriety of Hedge Accounting. .. available caps offered by counterparties in the light of its own assessment of future interest rate movements ©Cambridge Business Publishers, 2013 26 Advanced Accounting, 2nd Edition Find more... change (loss), will be recognized as realized revenue ©Cambridge Business Publishers, 2013 Advanced Accounting, 2nd Edition Find more at www.downloadslide.com b E9.3 Even though Daley intends to purchase