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Derivatives ModuleProblems

PROBLEMS
PROBLEM M-1
(1) The use of derivatives for speculative purposes is prohibited. Derivatives are used to manage market risk from changes in
foreign exchange rates, commodity prices, compensation liabilities, and interest rates.
(2) The hedging activity that has an impact on other comprehensive income is that which is associated with cash flow hedges.
Some of the hedges are used with respect to the variability in future cash flows attributable to changes in foreign currency
exchange rates or commodity price changes. In addition, the company uses interest rate swaps and treasury lock agreements
as cash flow hedges.
(3) A cash flow hedge is used to establish fixed prices or rates when future cash flows could vary due to changes in prices or rates.
The interest rate swaps that are used as cash flow hedges are designed to hedge against the adverse effects of variability in
cash flows associated with existing debt that has variable interest rates or with forecasted transactions, as is the case with the
treasury lock agreements related to the anticipated fixed rate note issuance to finance the acquisition of York. A fair value hedge
is used to offset changes in the fair value of items with fixed prices or rates. The interest rate swaps that qualify as fair value
hedges are not hedging against variability in cash flows but rather hedging against changes in the value of fixed rate debt. The
company hedged both its fixed rate 5% notes maturing in November 2006 and its 6.3% notes maturing in February 2008. In both
cases, the company received a fixed dollar rate of interest and paid interest based on a floating rate of LIBOR plus basis points.
(4) The hedge of the 6.3% notes requires the company to pay a fixed rate of 6.3%. Anticipating that variable or floating rates would
result in lower interest expense, the company agreed to pay to a counterparty a floating rate of LIBOR plus 283.5 basis points in
exchange for a fixed rate of 6.3%. The rate is reset every three months. Regarding the impact on earnings, the gain or loss on
the swap would be recorded as a change in the value of the swap and an offsetting gain or loss would be recorded as an
adjustment to the basis of the debt. Therefore, the net effect would be zero. However, the fixed interest expense on the debt
would be adjusted (increased or decreased) to reflect the settlement of interest rate differences. If the floating rate paid were
less than the fixed rate received, the company would experience a decrease in interest expense.

PROBLEM M-2
(1)

Corn Futures
Number of bushels. .........................
Spot price per bushel ......................
Futures price per bushel .................
Fair value of contract ....................
(a) Change in above fair value ....
(b) Change in spot rates:
At beginning of period .......
At end of period .................
Change ...................................

September 1 September 30
1,000,000
$2.5000
$2.5100
$

(a) (b) = Change in spot-forward


difference ................................
Wheat Futures
Number of bushels. .........................
Spot price per bushel ......................
Futures price per bushel .................
Fair value of contract ....................
(a) Change in above fair value ....
(b) Change in spot rates:
At beginning of period .......
At end of period .................
Change ...................................
(a) (b) = Change in spot-forward
difference ................................

Sept. 1

November 5

1,000,000
$2.5680
$2.5700

1,000,000
$2.5685
$2.5710

1,000,000
$2.5380
$2.5420
$
$

32,000
32,000

$
$

60,000
28,000

$
$

61,000
1,000

$2,500,000
2,538,000
$ 38,000

$2,538,000
2,568,000
$ 30,000

$2,568,000
2,568,500
$
500

(6,000)

September 1 September 30

(2,000)

500

October 31

November 5

2,000,000
$3.5480
$3.5520

2,000,000
$3.5700
$3.5710

2,000,000
$3.5700
$3.5705

62,000
62,000

$ 100,000
$ 38,000

$
$

$7,030,000
7,096,000
$ 66,000

$7,096,000
7,140,000
$ 44,000

$7,140,000
7,140,000
$

2,000,000
$3.5150
$3.5210
$

October 31

$
$

(4,000)

(6,000)

99,000
(1,000)

(1,000)

Memo entry to record the acquisition of the futures contract.


Margin Account ...................................................................
Cash ...............................................................................
To record margin account deposit.

70,000
70,000

30

Futures ContractCorn ......................................................


Futures ContractWheat ...................................................
Unrealized Hedging Loss ....................................................
Other Comprehensive Income ........................................
To record change in value of contract and
include in earnings change in time value
excluded from hedge effectiveness.

32,000
62,000
10,000
104,000

Problem M-2, Concluded


Oct. 31

Nov. 5

21

Futures ContractCorn ......................................................


Futures ContractWheat ...................................................
Unrealized Hedging Loss ....................................................
Other Comprehensive Income ........................................
To record change in value of contract and
include in earnings change in time value
excluded from hedge effectiveness.

28,000
38,000
8,000

Futures ContractCorn ......................................................


Unrealized Hedging Loss ....................................................
Futures ContractWheat ...............................................
Other Comprehensive Income ........................................
To record change in value of contract and
include in earnings change in time value
excluded from hedge effectiveness.

1,000
500

Cash .............................................................................
Futures ContractCorn..................................................
Futures ContractWheat ...............................................
Margin Account...............................................................
To record settlement of futures and return
of margin account.

230,000

74,000

1,000
500

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


Cost of SalesCorn .......................................................
Cost of SalesWheat ....................................................
To adjust cost of sales for the recognition
of gains on futures contracts.

61,000
99,000
70,000

68,500
110,000

(2) Factors that might cause the futures contracts to not be highly effective include the following:
a. Changes in the price of wheat and corn may not correlate as highly with the change in the price of flour due to costs
associated with producing flour.

b. The CBT prices reflect delivery of commodities at a location that is different than the location of commodities used to make
flour that is used by CBBI.
c. The quality of the commodities traded on the CBT may be different than the quality of the commodities used to make the
flour acquired by CBBI.
d. The quantity of flour used by CBBI and therefore the equivalent amount of corn and wheat may be greater than the notional
amount of the futures contracts. Therefore, some of the cash flows would not be hedged.

PROBLEMS
PROBLEM 10-1
Transaction A:
Gain (Loss)
Exchange gain on exposed payable
[100,000 FC ($1.140 $1.150)] ..............................
Loss on forward contract ..................................................
Net effect on earnings ......................................................

$ 1,000
(796)*
$ 204

*The total change in value of the contract is a loss of $796 [100,000 FC ($1.138 $1.146)] = $800. The NPV of $800 where n = 1
and i = 6%/12 = $796.
Transaction B:
Gain (Loss)
Gain on commitment
[100,000 FC ($1.150 $1.132)] ..............................

$ 1,800

Loss on forward contract


[100,000 FC ($1.150 $1.132)] ..............................
Adjustment to basis of sales revenue ...............................

(1,800)
(1,800)
$(1,800)

Transaction C:
Gain (Loss)
Change in time value
[100,000 FC ($1.120 $1.132)] ..............................
Depreciation expense
[(100,000 FC $1.150) 60 months] .........................
Reclassification of other comprehensive
income as current earnings
[100,000 FC ($1.150 $1.132) + $1,200]
Time value = $3,000 60 months ....................................

$(1,200)
(1,917)

50
$(3,067)

Transaction D:
Change in time value* ......................................................

$ (200)

*On November 30, the intrinsic value is $500 and the time value is $700, versus December 31, when the intrinsic value is $1,500 and
the time value is $500. Therefore, the change in time value is a loss of $200.

PROBLEM 10-2
Balance sheet accountsDebit (Credit):
Inventory of medical equipment .....................................
Firm commitment ..........................................................
Accounts receivable:
(800,000 FC $0.470) ............................................
Forward contract receivable:
(800,000 $0.510) ..................................................
Forward contract payable:
($408,000 $15,722) ..............................................
($408,000 $33,516) ..............................................
Income statement accountsDebit (Credit):
(Gain) loss on firm commitment .....................................
(Gain) loss on forward contract (see Note A) .................
Sales revenue:
(800,000 FC $0.480) ............................................
Adjusted for firm commitment ..................................
Adjusted sales revenue ...........................................
Cost of sales .................................................................
Exchange (gain) loss on receivable:
[800,000 FC ($0.470 $0.480)] ............................

2nd Quarter
$ 325,000
(15,722)

3rd Quarter
$

376,000
408,000

408,000

(392,278)
(374,484)
15,722
(15,722)

11,999
(17,794)*
$(384,000)
(27,721)
$(411,721)
$ 325,000
$

8,000

Note A:
June 1
Number of FC ........................................ 800,000
Spot rate 1 FC..................................... $ 0.500
Forward rate remaining time 1 FC = .... $ 0.510
Fair value of forward contract:
Original forward rate .........................
Current forward rate .........................
Change gain (loss) in forward rate
Present value of change:
n = 3.5, i = 0.50% .......................
n = 2.0, i = 0.50% .......................
n = 0.5, i = 0.50% .......................

June 30
800,000
$ 0.485
$ 0.490

August 15
800,000
$ 0.480
$ 0.475

September 30
800,000
$ 0.470
$ 0.468

$408,000
392,000
$ 16,000

$408,000
380,000
$ 28,000

$408,000
374,400
$ 33,600

$ 15,722
$ 27,721
$ 33,516

Change in value from prior period:


Current present value .................
Prior present value .....................
Change in present value .............

$ 15,722

$ 15,722

$ 27,721
15,722
$ 11,999

$ 33,516
27,721
$ 5,795

*The third quarter gain on the forward contract consists of the August 15 gain of $11,999 and the September 30 gain of $5,795 for a
total of $17,794.

PROBLEM 10-3
(1) The foreign currency transaction:
Sales (200,000 euros $1.180) ..............................................
Cost of goods sold ..................................................................
Gross profit .............................................................................
Exchange gain (loss):
200,000 euros ($1.179 $1.180) ....................................
200,000 euros ($1.175 $1.179) ....................................
Net income effect ....................................................................

March
$236,000
160,000
$ 76,000

April
$

(200)
$ 75,800

(800)
$(800)

March
$597
$597

April
$603
$603

March
$(593)
$(593)

April
$(896)
$(896)

March
$593
$593

April
$896
$896

Schedule A for Part (2)


March 1
March 31
200,000
200,000
$1.181
$1.178

April 30
200,000
$1.175

(2) The hedge on the foreign currency transaction:


Gain (loss) on forward contract (see Schedule A) ...................
Net income effect ....................................................................
(3) The foreign currency commitment:
Gain (loss) on firm commitment (see Schedule B) ..................
Net income effect ....................................................................
(4) The hedge on the foreign currency commitment:
Gain (loss) on forward contract (see Schedule B) ...................
Net income effect ....................................................................

Number of FC ..................................................
Forward rate remaining time1 FC .................

Fair value of original contract:


Original forward rate ...........................................................
Current forward rate ...........................................................
Changegain (loss) in forward rate ...................................

$236,200
235,600
$
600

$236,200
235,000
$ 1,200

Present value of change:


n = 1, i = 0.50% ..................................................................
n = 0, i = 0.50% ..................................................................
Change in value from prior period:
Current present value .........................................................
Prior present value .............................................................
(a) Change in present value ...............................................

$
$

597

597

597

1,200

1,200
597
603

Problem 10-3, Concluded


Schedule B for Parts (3 and 4)
March 15
March 31
Number of FC ..................................................
300,000
300,000
Forward rate remaining time1 FC .................
$1.179
$1.177
Fair value of original contract:
Original forward rate ...........................................................
Current forward rate ...........................................................
Changegain (loss) in forward rate ...................................
Present value of change:
n = 2.5, i = 0.50% ...............................................................
n = 1.5, i = 0.50% ...............................................................
Change in value from prior period:
Current present value .........................................................
Prior present value .............................................................
(a) Change in present value ...............................................

$353,700
353,100
$
600
$

$
$

April 30
300,000
$1.174
$353,700
352,200
$ 1,500

593

593

593

1,489

1,489
593
896

PROBLEM M-4
(1)
Date
December 31, 20X7 .......
March 31, 20X8 .............
June 30, 20X8................
September 30, 20X8 ......
December 31, 20X8 .......
Totals ........................

Payment
$1,136,408
1,136,408
1,136,408
1,136,408
$4,545,632

(2)
Date
June 30, 20X8................
September 30, 20X8 ......
December 31, 20X8 .......

Payment
$115,000
108,750

Interest
Quarterly Rate
Amount
1.25%
1.25
1.25
1.25

$157,383
145,145
132,754
120,208
$555,490

Interest
Quarterly Rate
Amount
1.1500%
1.0875

$115,000
108,750

Principal
$ 979,025
991,263
1,003,654
1,016,200
$3,990,142

Principal
$

Balance
$12,590,619
11,611,594
10,620,331
9,616,677
8,600,477

Balance
$10,000,000
10,000,000
10,000,000

Totals ........................
(3)
Date
March 31, 20X8 .............
June 30, 20X8................
September 30, 20X8 ......
December 31, 20X8 .......
Totals ........................
(4)
Date
September 30, 20X8 ......
December 31, 20X8 .......
Totals ........................

$223,750

$223,750

Balance at
Beginning
of Quarter
$12,590,619
11,611,594
10,620,331
9,616,677

Pay
Floating Rate
1.1875%
1.1625
1.1000
1.0375

Receive
Fixed Rate
1.1875%
1.1875
1.1875
1.1875

Net Swap
Interest
$

(2,903)
(9,293)
(14,425)
$(26,621)

Stated Interest
on Note
$157,383
145,145
132,754
120,208
$555,490

Net Interest
Expense
$157,383
142,242
123,461
105,783
$528,869

Balance at
Beginning
of Quarter
$10,000,000
10,000,000

Pay
Floating Rate
1.1500%
1.0875

Receive
Fixed Rate
1.1250%
1.1250

Net Swap
Interest
$(2,500)
3,750
$ 1,250

Stated Interest
on Note*
$122,500
116,250
$238,750

Net Interest
Income
$120,000
120,000
$240,000

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

Problem M-4, Concluded


(5) Pay floating rate interest per quarter ($10,000,000 1.0875%) .............
Receive fixed rate interest per quarter ($10,000,000 1.1250%) ..........
Difference per quarter ............................................................................

$108,750
112,500
$ 3,750

Number of quarters remaining ...............................................................

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

$ 14,601

(6) In addition to the risk that the interest income on the note would decline due to falling variable interest rates, there is now a
concern due to changing currency exchange rates. If the interest income is to be received in euros and the euros are exchanged
into dollars, it is possible that the number of dollars received could decline over time. This would be the case if the euro
weakened relative to the dollar.