Option Contracts
5-1
DEFINITIONS
5-2
•
Call:
The option holder has the right to
buy the underlying instrument at
the call’s exercise (strike) price
•
Put:
The option holder has the right to
sell the underlying instrument at
the put’s exercise (strike) price
WRITTEN OPTIONS UNDER FAS 133
A written option is sold by an "option writer" who sells options
collateralized by a portfolio of securities or other performance bonds.
Typically a written option is more than a mere "right" in that it requires
contractual performance based upon another party's right to force
performance. The issue with most written options is not whether they
are covered by FAS 133 rules. The issue is whether they will be
allowed to be designated as cash flow hedges. Written options are
referred to at various points in FAS 133. For example, see Paragraphs
20c, 28c, 91-92 (Example 6), 199, and 396-401.. For rules regarding
written options see Paragraphs 396-401 on Pages 179-181 of FAS
133. Exposure Draft 162-B would not allow hedge accounting for
written options. FAS 133 relaxed the rules for written options under
certain circumstances explained in Paragraphs 396-401.
Note that written options may only hedge recorded assets and liabilities.
They may not be used to hedge forecasted purchase and sales transactions.
5-3
PURCHASED OPTIONS UNDER FAS 133
Purchased options are widely used for hedging
and present some of the biggest challenges for
hedge accounting rules.
The major problem is that purchased option
values are often highly volatile relative to
value changes in the hedged item. Traditional
Delta effectiveness tests fail for hedge
accounting for full value.
5-4
OPTION PARTICIPANTS
5-5
Call Buyer
Pays premium
Has the right to buy
Call Seller
Collects premium
Has obligation to
sell, if assigned
Put Buyer
Pays premium
Has the right to sell
Put Seller
Collects premium
Has obligation to
buy, if assigned
IDENTIFYING OPTIONS
• Call or put
• Strike price (exercise price)
• Expiration date
• Underlying instrument
5-6
Option Strategies
http://www.optionetics.com/education/strategies/strategies.asp
Bullish Strategies
•Calls:
•Covered Calls:
•Vertical Spread:
•Bull Call Spread
•Bull Put Spread
Bearish Strategies :
•Buying Puts
•Covered Puts: Bear
•Call Spread
•Bear Put Spread
5-7
Delta Hedging
http://biz.yahoo.com/glossary/bfglosd.html
Delta hedge where delta = d(Option)/d(spot) = Hedge Ratio
A dynamic hedging strategy using options with continuous
adjustment of the number of options used, as a function of
the delta of the option.
Delta neutral
The value of the portfolio is not affected by changes in the
value of the asset on which the options are written.
5-8
Dynamic Hedging
http://biz.yahoo.com/glossary/bfglosd.html
Dynamic hedging
A strategy that involves rebalancing hedge positions as
market conditions change; a strategy that seeks to insure the
value of a portfolio using a synthetic put option.
5-9
SPOT/FORWARD PRICES
Price
Forward
Spot
Time
5-10
TIME VALUE / VOLATILITY VALUE
•
Time value is the option premium less intrinsic
value
– Intrinsic value is the beneficial difference
between the strike price and the price of the
underlying
•
Volatility value is the option premium less the
minimum value
– Minimum value is present value of the
beneficial difference between the strike price
and the price of the underlying
5-11
FEATURES OF OPTIONS
Option Value = Intrinsic Value + Time Value
5-12
• Intrinsic Value:
Difference between the strike
price and the underlying
price, if beneficial;
otherwise zero
• Time Value:
Sensitive to time and
volatility; equals zero at
expiration
Sub-paragraph b(c) of Paragraph 63 of FAS
133
c. If the effectiveness of a hedge with a
forward or futures contract is assessed
based on changes in fair value
attributable to changes in spot prices,
the change in the fair value of the
contract related to the changes in the
difference between the spot price and
the forward or futures price would be
excluded from the assessment of hedge
effectiveness.
5-13
Sub-paragraph b(a) of Paragraph 63 of FAS
133
a. If the effectiveness of a hedge with an
option contract is assessed based on
changes in the option's intrinsic value,
the change in the time value of the
contract would be excluded from the
assessment of hedge effectiveness.
5-14
Sub-paragraph b(b) of Paragraph 63 of FAS
133
b. If the effectiveness of a hedge with an
option contract is assessed based on
changes in the option's minimum value,
that is, its intrinsic value plus the effect
of discounting, the change in the
volatility value of the contract would be
excluded from the assessment of hedge
effectiveness.
5-15
THE IMPACT OF VOLATILITY
A
B
Price
Price
P*
P*
Time
5-16
Time
Minimum Value
Option Value = Risk Free Value + Volatility Value
If the underlying is the price of corn, then the minimum value of
an option on corn is either zero or the current spot price of
corn minus the discounted risk-free present value of the
strike price. In other words if the option cannot be exercised
early, discount the present value of the strike price from the
date of expiration and compare it with the current spot
price. If the difference is positive, this is the minimum
value. It can hypothetically be the minimum value of an
American option, but in an efficient market the current price
of an American option will not sell below its risk free present
value.
5-17
INTRINSIC VALUE / MINIMUM VALUE
Option
Price
Strike
Price
Minimum
Value
Intrinsic
Value
Underlying
Price
5-18
Minimum (Risk Free) Versus Intrinsic Value
European Call Option
•
•
X = Exercise (Strike) Price in n periods after current time
P = Current Price (Underlying) of Commodity
•
I = P-X>0 is the intrinsic value using the current spot price if the
option is in the money
•
M = is the minimum value at the current time
•
M>I if the intrinsic value I is greater than zero
Value of Option exceeds minimum M due to volatility value
5-19
Minimum (Risk Free) Versus Intrinsic Value
Arbitrate for European Call Option
•
•
•
•
•
•
•
•
X = $20 Exercise (Strike) Price and Minimum Value M = $10.741
n = 1 year with risk-free rate r = 0.08
P (Low) = $10 with PV(Low) = $9.259
P = $20 such that the intrinsic value now is I = P-X = $10.
Borrow P(Low), and Buy at $20 = $9.259+10.741 = PV(Low)+M
If the ultimate price is low at $10 after one year, pay off loan at
P(Low)=$10 by selling the commodity at $10.
If we also sold an option for M=$10.741, ultimately our profit
would be zero from the stock purchase and option sale.
If the actual option value is anything other than M=$10.741, it
would be possible to arbitrage a risk free gain or loss.
5-20
INTRINSIC VALUE / MINIMUM VALUE
Option
Price
Strike
Price
Minimum
Value
Intrinsic
Value
Underlying
Price
5-21
Minimum Versus Intrinsic Value
American Call Option
•
•
X = Exercise (Strike) Price in n periods after current time
P = Current Price (Underlying) of Commodity
•
I = P-X>0 is the intrinsic value using the current spot price if the
option is in the money
•
M = 0 is the minimum value since option can be exercised at any
time if the option’s value is less than intrinsic value I.
Value of option exceeds M and I due to volatility value
5-22
What’s Wrong With the Black-Scholes Model
When Valuing Options?
•
The Black-Scholes Model works pretty well for options on stocks.
It does not work well for interest rate and some commodity
options.
•
The main problem for interest rates is the assumption that shortterm interest rates are constant.
•
The assumption of constant variance is always a worry when using
this model to value any type of option.
•
The assumption of normality is always a worry when using this
model for valuing options of any type.
5-23
LONG OPTION HEDGES
•
Fair value hedges
– Mark-to-market of the option will generally be
smaller than exposure’s contribution to
earnings
•
Cash flow hedges
– Changes in intrinsic values of options go to
–
other comprehensive income to the extent
effective*
Remaining changes in option prices goes to
current income
* Bounded by the magnitude of the exposures’ price changes
5-24
GENERAL RECOMMENDATIONS
5-25
•
For most static option hedges: Exclude time value
from hedge effectiveness considerations
•
For most fair value hedges: Exclude forward
points from hedge effectiveness considerations
•
For non-interest rate cash flow hedges: Assess
effectiveness based on comparisons of forward
prices
•
For options: Consider the FAS Paragraph 167
alternative for minimum value hedging.
“THE RISK BEING HEDGED”
•
For non-interest rate exposures
– Entities must identify their firm-specific
exposures as hedged items
– Differences between firm-specific prices
and hedging instruments’ underlying
variables will foster income volatility
– Pre-qualifying hedge effectiveness
documentation is required for all crosshedges
5-26
Selected IAS 39 Paragraph Excerpts
•
•
•
•
•
•
•
146. 80%<Delta<125% Guideline.
147. Assessing hedge effectiveness will depend on its risk management strategy.
148. Sometimes the hedging instrument will offset the hedged risk only partially.
149. The hedge must relate to a specific identified and designated risk, and not merely to overall enterprise business
risks, and must ultimately affect the enterprise's net profit or loss.
150. An equity method investment cannot be a hedged item in a fair value hedge because the equity method
recognizes the investor's share of the associate's accrued net profit or loss, rather than fair value changes, in net
profit or loss. If it were a hedged item, it would be adjusted for both fair value changes and profit and loss accruals which would result in double counting because the fair value changes include the profit and loss accruals. For a
similar reason, an investment in a consolidated subsidiary cannot be a hedged item in a fair value hedge because
consolidation recognizes the parent's share of the subsidiary's accrued net profit or loss, rather than fair value
changes, in net profit or loss. A hedge of a net investment in a foreign subsidiary is different. There is no double
counting because it is a hedge of the foreign currency exposure, not a fair value hedge of the change in the value of
the investment.
151. This Standard does not specify a single method for assessing hedge effectiveness.
152. In assessing the effectiveness of a hedge, an enterprise will generally need to consider the time value of money.
5-27
FAS Effectiveness Testing --http://www.qrm.com/products/mb/Rmbupdate.htm
•
•
•
•
•
Dollar Offset (DO) calculates the ratio of dollar change in profit/loss for hedge
and hedged item
Relative Dollar Offset (RDO) calculates the ratio of dollar change in net position
to the initial MTM value of hedged item
Variability Reduction Measure (VarRM) calculates the ratio of the squared dollar
changes in net position to the squared dollar changes in hedged item
Ordinary Least Square (OLS) measures the linear relationship between the dollar
changes in hedged item and hedge. OLS calculates the coefficient of
determination (R2) and the slope coefficient (ß) for effectiveness measure and
accounts for the historical performance
Least Absolute Deviation (LAD) is similar to OLS, but employs median
regression analysis to calculate R2 and ß.
5-28
Regression Versus Offset Effectiveness Tests
5-29
The Dictionary of Financial Risk Management defines
dynamic hedging as follows ---
http://snipurl.com/DynamicHedging
•
5-30
Dynamic Hedging:
A technique of portfolio insurance or position risk management in
which an option-like return pattern is created by increasing or
reducing the position in the underlying (or forwards, futures or
short-term options in the underlying) to simulate the Delta change in
value of an option position. For example, a short stock futures index
position may be increased or decreased to create a synthetic put on a
portfolio, producing a portfolio insurance-type return pattern.
Dynamic hedging relies on liquid and reasonably continuous
markets with low to moderate transaction costs. See Continuous
Markets, Delta Hedge, Delta/Gamma Hedge, Portfolio Insurance.
Dynamic Hedging
Paragraph 144 of IAS 39 Reads as Follows
144. There is normally a single fair value measure for a hedging
instrument in its entirety, and the factors that cause changes in
fair value are co-dependent. Thus a hedging relationship is
designated by an enterprise for a hedging instrument in its
entirety. The only exceptions permitted are (a) splitting the
intrinsic value and the time value of an option and designating
only the change in the intrinsic value of an option as the hedging
instrument, while the remaining component of the option (its
time value) is excluded and (b) splitting the interest element and
the spot price on a forward. Those exceptions recognize that the
intrinsic value of the option and the premium on the forward
generally can be measured separately. A dynamic hedging
strategy that assesses both the intrinsic and the time value of an
option can qualify for hedge accounting.
5-31
New Example
New Example Coming Up
5-32
Example 9, Para 162, FAS 133 Appendix B
Cash Flow Hedge Using Intrinsic Value
•
XYZ specified that hedge effectiveness will be
measured based on changes in intrinsic value
•
The American call option purchased at 1/1/X1
has a four-month term
•
The call premium is $9.25, the strike rate is
$125, and the option is currently at-the-money
See 133ex09a.xls at
http://www.cs.trinity.edu/~rjensen/
•
•
5-33
Also see
http://www.trinity.edu/rjensen/caseans/IntrinsicValue.htm
Example 9 from FAS 133 Paragraph 162
With 100% Delta Effectiveness
Forecasted Transaction
Entry
Date
Value
Jan. 01
$125.00
Option
Option
Time
Intrinsic
Value
Value
$9.25 = Premium
$0
$0.00 = Intrinsic Value
$9.25 = Time Value
5-34
Example 9 from FAS 133 Paragraph 162
January 31
Forecasted Transaction
Entry
Date
Value
Jan. 01
$125.00
Jan. 01
Call option
Cash
Option
Time
Value
$9.25
Debit
9.25
Option
Intrinsic
Value
$0
Credit Balance
9.25
9.25
(9.25)
For cash flow hedges, adjust hedging derivative to fair value and offset to
OCI to the extent of hedge effectiveness.
5-35
Example 9 from FAS 133 Paragraph 162
With 100% Delta Effectiveness
Forecasted Transaction
Entry
Date
Value
Jan. 01
$125.00
Jan. 31
$127.25
Option
Time
Value
$9.25 = Premium
$7.50
Option
Intrinsic
Value
$0
$2.25
$2.25 = Change in Hedged Intrinsic Value
$2.25 = Change in Hedge Contract Intrinsic Value
Delta = 1.00 or 100% based on intrinsic value
Delta = 0.44 = 44% = |(9.75-9.25)/ (127.25-125.00)|
5-36
Total
Option
Value
$9.25
$9.75
Example 9 from FAS 133 Paragraph 162
January 31
Forecasted Transaction
Entry
Date
Value
Jan. 01
$125.00
Jan. 31
$127.25
Jan. 31
Call option
P&L
OCI
Option
Time
Value
$9.25
$7.50
Debit
0.50
1.75
Option
Intrinsic
Value
$0
$2.25
Credit Balance
9.75
1.75
2.25
(2.25)
For cash flow hedges, adjust hedging derivative to fair value and offset to
OCI to the extent of hedge effectiveness.
5-37
Example 9 from FAS 133 Paragraph 162
February 28
Forecasted Transaction
Entry
Date
Value
Jan. 31
$127.25
Feb. 28
$125.50
Option
Time
Value
$7.50
$5.50
Feb. 28
Debit
1.75
2.00
OCI
P&L
Call option
Option
Intrinsic
Value
$2.25
$0.50
Credit
3.75
Balance
(0.50)
3.75
6.00
For cash flow hedges, adjust hedging derivative to fair value and offset to
OCI to the extent of hedge effectiveness.
5-38
Example 9 from FAS 133 Paragraph 162
March 31
Forecasted Transaction
Entry
Date
Value
Feb. 28
$125.50
Mar. 31
$124.25
Option
Time
Value
$5.50
$3.00
Debit
Mar. 31 OCI
0.50
P&L
2.50
Call option
Option
Intrinsic
Value
$0.50
$0.00
Total
Option
Value
$6.00
$3.00
Credit Balance
0
6.25
3.00
3.00
For cash flow hedges, adjust hedging derivative to fair value and offset to OCI to the extent
of hedge effectiveness.
5-39
Example 9 from FAS 133 Paragraph 162
April 30
Forecasted Transaction
Entry
Date
Value
Jan. 01
$125.00
Mar. 31
$124.25
Apr. 30
$130.75
Apr. 30
5-40
Option
Time
Value
$9.25
$3.00
$0.00
Debit
Call option 2.75
P&L
3.00
OCI
Option Total
Intrinsic Option
Value
Value
$0.00
$9.25
$0.00
$3.00
$5.75
$5.75
Credit Balance
5.75
9.25
5.75
5.75
Example 9 from FAS 133 Paragraph 162
With No Basis Adjustment Under FAS 133
Apr. 30
Apr. 30
Apr. 30
Cash
Call option
OCI
Debit
5.75
Credit
5.75
Balance
-$3.50
$0
No basis adjustment yet
P&L
No basis adjustment yet
Inventory
130.75
$130.75
Cash
130.75
-$134.25
Cash = -$9.25 Premium +$5.75 Call Option - $130.75 = -$134.25
5-41
Example 9 from FAS 133 Paragraph 162
With No Basis Adjustment Under FAS 133
May 14
May 14
May 14
5-42
Debit
Cash
234.25
P&L (or Sales)
Balance
+$100.00
234.25 -$225.00
P&L (or CGS)
Inventory
OCI
P&L
-$ 94.25
130.75
$ 0
$ 0
5.75 -$100.00
130.75
5.75
Credit
Example 9 from FAS 133 Paragraph 162
With Basis Adjustment Under IAS 39
Apr. 30
Apr. 30
Cash
Call option
OCI
Debit
5.75
5.75
5.75
P&L
Apr. 30
5-43
Credit
Inventory
Cash
5.75
130.75
130.75
FUTURES /FORWARDS vs. OPTIONS
Futures / Forwards
Long Options
Unlimited risk/reward
Limited risk/unlimited reward
No initial payment
Initial payment of premium
Offsets risk and opportunity
Offsets risk/allows opportunity
5-44
FUTURES vs. OPTIONS
Speculators
Futures
Long: Bullish
Short: Bearish
Long Calls
unlimited gain
unlimited risk
unlimited gain
limited risk
Bullish
Long Puts
Bearish
unlimited gain
limited risk
Lock in a price Protect against Protect against
rising price
falling price
Hedgers Long: Buy price
Short: Sell price (for a premium) (for a premium)
5-45
OPTION VALUATION PRACTICES
5-46
•
Actively traded, liquid contracts
– Use market data
•
Where no market is available
– Requires “marking-to-model”
– Valuations will differ depending on the
particular model used, and the inputs to the
model
•
Market values should reflect present values of
expected future cash flows
Why Discounted Cash Flow
Does Not Work Well for Valuing Options
American: Can exercise anytime up to,
and including expiration date
European: Can exercise only on
expiration date, but may be able to
sell the option at current value
Risk: Risk varies over time making DCF
valuation ineffective
5-47
GENERAL FEATURES OF
OPTIONS ON FUTURES
Option prices move in variable proportion to
futures prices:
Deep In-the-money
.
.
.
.
Deep Out-of-the-money
5-48
High proportion
(almost one-to-one) .
.
.
.
Low proportion
(almost zero-to-one)
GENERAL FEATURES OF
OPTIONS ON FUTURES
5-49
•
Deltas increase as options move (deeper) in-themoney
•
Deltas are bounded between a minimum of zero
and a maximum absolute value of one
•
Time value is greatest for at-the-money options
MEAN AND STANDARD DEVIATION
3 S.D.
2 S.D.
1 S.D.
Mean
5-50
STANDARD DEVIATION
5-51
•
1 standard deviation is the range associated
with a probability of 68.3%
•
2 standard deviations is the range associated
with a probability of 95.4%
•
3 standard deviations is the range associated
with a probability of 99.7%
NORMAL DISTRIBUTIONS
Frequency
High volatility
Low volatility
Returns
5-52
STANDARD DEVIATION
An Example
If the standard deviation is 10%, that means...
5-53
Probability
Expected
Price Change
68.3%
within 10% (1s.d.)
95.4%
within 20% (2s.d.)
99.7%
within 30% (3s.d.)
CALCULATING HISTORICAL
VOLATILITY
VOL = SD   T
Where:
VOL = Annualized volatility
SD = Standard deviation of periodic price
changes (closing prices)
T
5-54
= Number of trading periods per year
VOLATILITY EXAMPLE
24% Annual Volatility
Daily SD = (24%  254)  (24%  16)  1.5%
68.3% probability that overnight change  +/- 1.5%
95.4% probability that overnight change  +/- 3.0%
99.7% probability that overnight change  +/- 4.5%
5-55
IMPLIED VOLATILITIES
5-56
•
•
Derived from current options prices
•
Typically differ (significantly) from historical
volatilities
•
Generally differ across strike prices and
maturities
Reflect probability distributions of
forthcoming price changes (i.e., the annualized
standard deviations)
OPTION PRICE DETERMINANTS
+
+ +e –
Premium = f (IV, time, vol , r)
• Intrinsic value (IV)
• Time to expiration (time)
• Expected volatility (vole )
• Interest rates (r)
The implied volatility of a “similar” option
is the best input for expected volatility
5-57
SWAPS vs. CAPS/FLOORS
Effective
Rate
Effective
Rate
Floor
Cap
Swap
Swap
R*
(R* + PCap = RSwap)
5-58
Spot
Rate
R*
(R* - PFloor = RSwap)
Spot
Rate
BUILDING CAPS
•
•
•
•
•
5-59
A cap is a series of individual options (caplets),
each relating to a specific rate-setting date
The price of a cap is the sum of caplet prices
Option horizons (times to expiration) increase
for successive rate-setting dates
All else equal, longer-dated caplets are more
expensive than shorter dated caplets
Normal yield curves (i.e., expectations of rising
interest rates) inflate longer dated caplets, and
vice versa
FORWARD RATES
10.00%
7% Strike Yield
8.00%
6.00%
4.00%
2.00%
0.00%
4
5-60
8
12
16
20
24
Quarters
28
32
36
40
INTEREST RATE CAPS
5-61
Cap Levels
8%
2-Year
3-Year
4-Year
1.88%
3.53
5.43
9%
Premiums
1.06%
2.42
3.94
10%
0.62%
1.64
2.85
TWO YEAR COLLAR
Buy Caps at 8% or 9%; Sell Floor at 7.00%
Collar Levels
Cap Premium
Floor Premium
Net Cost
5-62
8% / 7%
1.88%
0.58
1.30%
9% / 7%
1.06%
0.58
0.48%
TWO YEAR CORRIDOR
Buy Caps at 8% or 9%; Sell caps at 10.00%
Corridor Levels
Long Cap Premium
Short Cap Premium
Net Cost
5-63
8% / 10%
9% / 10%
1.88%
0.62
1.26%
1.06%
0.62
0.44%
“QUASI-INSURANCE”
Examples
Collar: Constrains outcomes
at price extremes
Hedged
Hedged
S1
5-64
Corridor: Fixes outcomes
within a range of prices
S2
Spot
S1
S2
Spot
New Example
New Example Coming Up
5-65
CASE 7 - Cash Flow Hedge of Forecasted
Treasury Note Purchase
•
On 1/1/X1, XYZ forecasts a 12/31/X1 purchase of
$100 million 5-year 6% Treasury notes to be
classified AFS
•
At 1/1/X1 the 1-year forward rate for 5-year
Treasury notes is 6 %
•
XYZ wants to lock in at least the 6% yield for the
$100 million Treasury note purchase
•
XYZ’s hedge strategy is to purchase a call option
on $100 million of the 5-year Treasury notes that
have a 6% 1-year forward rate
5-66
CASE 7 - Cash Flow Hedge of Forecasted
Treasury Note Purchase
5-67
•
XYZ specified that hedge effectiveness will be
measured based on the total price change of
the Treasury notes and the intrinsic value of
the option (zero at 1/1/X1)
•
The American call option purchased at 1/1/X1
has a 1-year term
•
The call premium is $1.4 million, the strike
rate is 6%, and the option is currently at-themoney
CASE 7 - Cash Flow Hedge of Forecasted
Treasury Note Purchase
On 1/1/X1, the following activity is recorded:
Call option asset
Cash
1,400,000
To record the option purchase
5-68
1,400,000
CASE 7 - Cash Flow Hedge of Forecasted
Treasury Note Purchase
At 6/30/X1, the 12/31X1 forward 5-year Treasury
rate has declined 100 basis points from 6% to 5%
and the market price is 104.376. The following entry
is recorded to reflect the increase in the call option’s
intrinsic value.
Call option asset
OCI
4,376,000
4,376,000
To record the call option’s intrinsic value (assuming a
price of 104.376, calculated as $500,000 annuity
received for 10 semiannual periods discounted at
5% = $4,376,000).
5-69
CASE 7 - Cash Flow Hedge of Forecasted
Treasury Note Purchase
(continued)
At 6/30/X1, XYZ also determines that the call
option’s time value has decreased
Earnings
Call option asset
800,000
800,000
To record call option’s time value decrease
5-70
CASE 7 - Cash Flow Hedge of Forecasted
Treasury Note Purchase
At 12/31/X1, XYZ exercises the option and takes delivery
of the Treasury notes:
Earnings
600,000
Call option asset
To write off option time value balance
Treasury notes
100,000,000
Cash
Treasury notes (premium)
4,376,000
Call option asset
To record exercise of option
5-71
600,000
100,000,000
4,376,000
CASE 7 - Cash Flow Hedge of Forecasted
Treasury Note Purchase
5-72
•
The 12/31/X1 OCI balance of $4,376,000 is
reclassified into earnings over the life of the bond.
The interest method is used to calculate the
periodic amount reclassified into earnings.
•
The $4,376,000 Treasury note premium is
amortized over the life of the bond and offsets the
above OCI impact.
•
On a cash flow and earnings basis, XYZ succeeded
in locking in a minimum 6% return on the
Treasury notes as if these were purchased at par.
CASE 7 - Cash Flow Hedge of Forecasted
Treasury Note Purchase
XYZ demonstrates that the hedge was effective
as follows:
Price of a 6% bond purchased in a
5% rate environment
Less call option proceeds
Net price
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$104,376,000
(4,376,000)
$100,000,000
CASE 7 - Cash Flow Hedge of Forecasted
Treasury Note Purchase
If XYZ sold the $100 million bond on
6/30/X2, the remaining OCI balance is
reclassified into earnings because the
hedged item no longer affects earnings.
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New Example
New Example Coming Up
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CASE 8
Fair Value Hedge of AFS Security
•
XYZ owns 1,000 shares of ABC worth $100 each
($100,000)
•
•
XYZ wants to hedge downside price risk
•
Effectiveness is measured by comparing decreases
in fair value of investment with intrinsic value of
option
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On 1/1/X1, XYZ purchases an at-the-money put
option on 1,000 ABC shares expiring in 6 months;
exercise price is $100; option premium is $15,000
CASE 8
Fair Value Hedge of AFS Security
ABC Shares
Value at
1/1/X1
$100,000
Value at
3/31/X1
$ 98,000
Gain/
(Loss)
($ 2,000)
Put Option:
Intrinsic value
Time value
Total
$ 0
15,000
$ 15,000
$ 2,000
8,000
$ 10,000
$ 2,000
(7,000)
($ 5,000)
Note: The time value of the option includes the volatility
value and the effects of discounting.
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CASE 8
Fair Value Hedge of AFS Security
Journal entry at 1/1/X1
Option Contract
Cash
15,000
15,000
To record payment of option premium
No journal entry for hedged item
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CASE 8
Fair Value Hedge of AFS Security
Journal entries at 3/31/X1
Earnings
Investment in ABC
2,000
2,000
To record loss on investment in ABC
Earnings (time value)
Option contract
Earnings (intrinsic value)
To record activity up to 3/31/X1
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7,000
5,000
2,000