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Chapter 3.2, FAR340072, FAR311439, FAR316856, FAR317229, FAR317423,…
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FAR311439
Smythe Co. invested $200 in a call option for 100 shares of Gin Co. $.50 par common stock, when the market price was $10 per share. The option expired in three months and had an exercise price of $9 per share. What was the intrinsic value of the call option at the time of initial investment?
The intrinsic value of a stock option is calculated as the difference between the market price of the stock and the strike price or the exercise price. Therefore, the intrinsic value of the call option at the time of initial investment is $100 ($10 - $9) x 100 shares.
FAR316856
On November 1, year 2, Kir Co. signed a contract to purchase 10,000 British pounds on February 2, year 3. The relevant exchange rates are as follows:
Spot rate Forward rate
Speculation (non-hedge) is an attempt to profit from market changes (not for hedging purposes). Unrealized gains and losses are reported in income from continuing operations on the income statement. On December 31 year 2, Kir would report gain of $100 [i.e. ($2.06 - $2.05) x £10,000].
November 1, year 2 $1.98 $2.05
December 31, year 2 2.00 2.06
Kir accounts for the forward contract as a speculative transaction. What amount of gain, if any, should Kir report from this forward contract in its income statement for the year ended December 31, year 2?
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FAR317569
Zetablue Systems Inc. borrowed $1 million for five years with an interest rate of 6-month LIBOR + 1% on March 31, 2018. Due to economic slowdown, the interest rate has increased in the last 1 year and the company is concerned about the high interest rate. Zetablue enters a 5-year interest rate swap contract with North Seattle Investments. As per the contract, Zetablue will pay a fixed interest rate of 8%; receive the variable interest rate of 6-month LIBOR + 1%. Assume the debt and swap payments are made in every quarter. Following are the 6-month LIBOR rate and the market value of the swap agreement estimated by a swap broker.
How will the change in fair value of swap agreement on June 30, 2018 be recognized?
The hedge is a cash flow hedge. Zetablue is hedging against the risk of loss from the variability of its liability—a long-term debt. Secondly, the fair value of its debt is irrelevant as it has to repay the principal amount. As it is a cash flow hedge it will be recognized as part of the other comprehensive income in the balance sheet. The value of the swap agreement is $150,000 as on June 30. So the swap agreement is debited with $150,000 and the other comprehensive income is credited with $150,000.
FAR317654
A hedge is an investment to reduce the risk of adverse price movements in an asset. Which of the following is the risk associated with imperfect hedging activities?
Basis risk is the risk of loss from ineffective hedging activities. Basis risk is the difference between the fair value (or cash flows) of the hedged item and the fair value (or cash flows) of the hedging derivative. The entity is subject to the risk that fair values (or cash flows) will change so that the hedge will no longer be effective.
FAR317655
A hedge is an investment to reduce the risk of adverse price movements in an asset. The effective portion of the change in the fair value of a derivative designated and qualifying as a cash flow hedge is reported in:
Unrealized gains and losses attributed to changes in a derivative’s fair value are accounted for differently, depending on whether the derivative is designated and qualifies as a hedge. The effective portion of the change in the fair value of a derivative designated and qualifying as a cash flow hedge is reported in other comprehensive income and the ineffective portion is reported in earnings.
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FAR317279
Greenivory Inc. entered a 6-month forward contract to purchase Eur25 million at an exchange rate of $1.14 per Euro. At the end of the contract, the exchange rate is $1.1 per Euro. What is the notional amount of the contract?
The notional amount is a specified unit of measure- it could be the number of currency units, shares, bushels, pounds or other units specified in the contract. In this, the notional amount is EUR25 million.
FAR316977
Ronni Ltd. which has a June 30 balance sheet date manufactures furniture. An important raw material that is used in the production of the furniture is imported from another country and as such is prone to risks associated with changes in exchange rates. In August every year, Ronni needs 100,000 kg of the raw material to meet the extraordinary demand that arises due to a local annual festival. The raw material prices are prone to changes, Ronni has contacted one of the bank in the country and entered into a future contract on May 1 to buy the material on July 31 for $27 per kg. Spot rates and forwards rates are as follows:
What is the journal entry to be recorded on June 30?
Fair value measurements are required for derivatives. The future contract has to be recorded at fair value and any changes in the fair value must to be reflected in the financial statements. A cash flow hedge is a hedge against the risk of loss from a planned or forecasted future transaction, but not yet a legal commitment. Any changes in fair value would be recorded in the other comprehensive income (OCI) as this is only an anticipated transaction and nothing can go into the statement of income till the transaction actually occurs. Ronni has entered into a futures contract to hedge against an anticipated future change in exchange rate to buy the raw material at $27 per kg on July 31. As this is a hedge against the risk of loss from a forecasted transaction, this is a cash flow hedge. Any gain or loss due to the change in the fair value of the effective portion of the cash flow hedge (E of PACE) would be recognized in the other comprehensive income. The amount to be recognized is the difference between the strike price of $27 and the futures rate on June 30 of $30. The price has increased, Ronni would recognize a gain in the OCI for $3 (i.e. $30 - $27). The journal entry would be debit futures contract and credit other comprehensive income for $300,000.
FAR317277
Three months ago, Lui Petrochemicals Inc. entered a 1-year forward contract to purchase crude oil from KM Inc. at a price of $75. Assume the current oil price is $65, the oil price was $60 three months ago and is expected to have an average monthly increase of $1.5. What is the value of the forward contract at the beginning of the contract?
At the inception of the forward contract, the value of the forward contract is zero. It must be noted that the forward price and forward value are not the same. Forward contracts do not require early payment or down payment unlike some other future commitment derivative instruments. No money is exchanged at the initial agreement and no value can be attributed to it.
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FAR317663
Swaption is an option:
Swaption is an option of a swap that provides the holder with the right to enter into a swap at a specified future date with specified terms or to extend or terminate the life of an existing swap. These derivatives have characteristics of an option and an interest rate swap.
FAR317654
A hedge is an investment to reduce the risk of adverse price movements in an asset. Which of the following is the risk associated with imperfect hedging activities?
Basis risk is the risk of loss from ineffective hedging activities. Basis risk is the difference between the fair value (or cash flows) of the hedged item and the fair value (or cash flows) of the hedging derivative. The entity is subject to the risk that fair values (or cash flows) will change so that the hedge will no longer be effective.
Option (b) is incorrect because this represents the risk of loss as a result of the counterparty to a derivative agreement failing to meet its obligation.
Option (c) is incorrect because this represents a risk associated from using the insufficiently accurate models to value securities.
Option (d) is incorrect because this represents the risk of loss from adverse changes in market factors that affect the fair value of a derivative, such as interest rates, foreign exchange rates and market indexes for equity securities.