Chapter 11
Derivative Financial Instruments:
Futures , Options and Financial Swaps
SUMMARY OF ASSIGNMENT MATERIAL
Item
Topics Covered
Level
Time
Q11.1
Apply SFAS 133 definition of financial
instruments to callable convertible preferred
stock.
Mod
10-15
Q11.2
Explain the four characteristics of derivative
financial instruments specified in SFAS 133.
Mod
10-15
Q11.3
Define derivative financial instrument; explain
users= interests in an entity=s use of derivatives.
Low
5-10
Q11.4
Explain Ahedge accounting@ under SFAS 133.
Mod
10-15
Q11.5
Explanation of how futures contracts can also
increase risk.
Low
10-15
Q11.6
Explain treatment of value changes of derivatives
serving as (1) fair value hedges and (2) cash flow
hedges.
Mod
10-15
Q11.7
Description of how options differ from futures
and forward contracts.
Low
10-15
Q11.8
Explain the terms naked option writer and
covered option writer, and discuss the risk
associated with each.
Mod
15-20
Q11.9
Discuss how a put option can be used to hedge
against movements in interest rates.
Mod
10-15
Q11.10 Discuss the most significant risk assumed by
counterparties engaged in an interest rate swap
and how it can be avoided.
Mod
15-20
11-1
SUMMARY OF ASSIGNMENT MATERIAL (cont=d.)
Item
Topics Covered
Level
Time
Q11.11 Describe obligation swapped by fixed rate payer
Mod
and floating rate payer in plain vanilla interest rate
swap and factors motivating counterparties to
enter an interest rate swap.
10-15
Q11.12 Describe approach to valuing financial swaps and
explain whether computed value is an asset or
liability.
High
10-15
Q11.13 Discuss principal reasons for extensive
disclosures about derivatives.
Low
5-10
E11.1
Journal entries for short futures contract; calculate Mod
profit without hedge.
20-25
E11.2
Assess initial and continuing hedge effectiveness
and earnings impact.
Mod
15-20
E11.3
Journal entries for long futures contract; calculate
gain/loss from hedging.
Mod
20-25
E11.4
Journal entries for short futures contract.
Low
10-15
E11.5
Economics of hedging with futures contracts; how Mod
hedging fixes the price paid; propriety of hedge
accounting.
15-20
E11.6
Understanding economics of hedging with
options; how hedging limits the price paid; argue
against use of hedge accounting.
Mod
15-20
E11.7
Journal entries for interest rate cap and loan
interest.
Mod
20-25
E11.8
Journal entries for put options on bonds.
Mod
25-30
E11.9
Journal entries for call options on foreign
currency.
Mod
25-30
11-2
SUMMARY OF ASSIGNMENT MATERIAL (cont=d.)
Item
Topics Covered
Leve
Time
l
E11.10
Assess hedge effectiveness when using options;
financial statement effects.
Mod
20-30
E11.11
Interpretation of Disney financial instrument
disclosures.
Mod
20-30
E11.12
Computation of annual interest rate advantage to
companies involved in an interest rate swap;
resulting net interest rate spread.
Mod
20-25
E11.13
Computation of monthly profit and effect of
default on an interest rate swap.
Mod
20-25
E11.14
Journal entries for data in E11.13 assuming no
default.
Mod
20-30
E11.15
Journal entries for debt and related interest rate
swap; alternative scenario.
Mod
20-25
P11.1
Journal entries for short futures contract; calculate Mod
cash gain/loss on hedged transaction; compare
with cash gain/loss if futures contract was long.
20-30
P11.2
Journal entries for interest rate futures; show how
the futures fix the annualized return on Treasury
bill investment.
High
20-30
P11.3
Apply interest rate futures in a fair value hedge;
income statement effects, journal entries;
propriety of hedge accounting.
Mod
25-35
P11.4
Advantages and disadvantages of hedging with
futures contracts; point of indifference between
hedging and not hedging; show differential
High
25-35
11-3
financial statement effects.
SUMMARY OF ASSIGNMENT MATERIAL (cont=d.)
Item
Topics Covered
Level
Time
P11.5
Use data in P11.4 and explain advantages and
disadvantages of hedging with options; calculate
point of indifference between hedging and not
hedging; show differential financial statement
effects.
High
25-35
P11.6
Short answer questions on currency options.
High
20-30
P11.7
Present value analysis of desirability of interest
rate cap under two scenarios; journal entries for
interest expense and the cap.
High
30-40
P11.8
Journal entries for put options; calculation and
timing of recognition of gain/loss under SFAS
115.
Mod
25-35
P11.9
Journal entries for put and call options used as
straddle; calculate cash gain/loss on straddle.
Mod
25-30
P11.10
Determination of the viability and effect of
interest rate swaps on the parties involved in four
different situations.
Mod
30-40
P11.11
Evaluate strategies for hedging floating rate debt.
High
30-40
P11.12
Journal entries for interest rate swap; valuation
and mark to market.
High
40-50
P11.13
Criticize and revise swap terms that are the
reverse of what is needed; calculate cash
savings/loss produced by the swaps.
Mod
25-35
P11.14
Analyze the differential effect of SFAS 133 on the
reporting of futures, options, and interest rate
High
35-45
11-4
swaps. Discuss conditions favoring use of these
derivatives in hedging.
CARRYBACK TABLE
The carryback table identifies the assignment items which are new in this
edition and those which are carried over from the seventh edition. For the
latter, the problem number in the seventh edition is shown.
New Problem
Number
Source
New
Problem
Number
Source
New
Problem
Number
Source
Q11.1
Q11.1
E11.1
E11.1
P11.1
P11.1
Q11.2
Q11.2
E11.2
E11.2
P11.2
P11.2
Q11.3
Q11.3
E11.3
E11.3
P11.3
P11.3
Q11.4
Q11.4
E11.4
E11.4
P11.4
P11.4
Q11.5
Q11.5
E11.5
E11.5
P11.5
P11.5
Q11.6
Q11.6
E11.6
E11.6
P11.6
P11.6
Q11.7
Q11.7
E11.7
E11.7
P11.7
P11.7
Q11.8
Q11.8
E11.8
E11.8
P11.8
P11.8
Q11.9
Q11.9
E11.9
E11.9
P11.9
P11.9
Q11.10
Q11.10
E11.10
E11.10
P11.10
P11.10
Q11.11
Q11.11
E11.11
new
P11.11
new
Q11.12
Q11.12
E11.12
E11.12
P11.12
P11.12
Q11.13
Q11.13
E11.13
E11.13
P11.13
P11.13
E11.14
E11.14
P11.14
new
11-5
E11.15
E11.15
Carryforward tables for all chapters, identifying the disposition of seventh
edition assignment items, appear at the beginning of the solutions manual.
ANSWERS TO QUESTIONS
Q11.1
The holder of callable convertible preferred stock has the contractual right to
convert the preferred stock to common stock in accordance with a known
formula or conversion ratio. Provision (1) in the financial instrument
definition refers to this contractual conversion right.
Existence of the call provision, however, provides the issuer with flexibility
that may rebound to the disadvantage of the holder. A callable security
generally has a call price higher than issue price or par value. Nevertheless, by
calling the stock the issuer can force conversion into common stock where a
variable common dividend replaces a fixed preferred dividend. Or, if the
conversion ratio is unfavorable to the holder, the holder is forced to relinquish
the convertible preferred stock and possibly to incur additional transaction
costs to obtain replacement investments.
Q11.2
1.
Derivatives are tied to underlyings, variables that are subject to price
changes. Thus derivatives are not tied to assets or liabilities themselves,
but to the prices of those assets or liabilities.
2.
Derivatives are based on a contractual or notional amount, a quantity of
units to which the change in the underlying is applied.
3.
Derivatives require either no initial investment or a nominal amount, not
an amount approximating the value of the notional amount.
4.
Derivatives provide for net cash or cash-equivalent settlement. Delivery
of the notional amount is not required and the position can be settled by
entering an offsetting derivative contract or by making a net cash
payment equal to the product of the change in the underlying and the
11-6
notional amount.
Q11.3
A derivative financial instrument is a financial instrument whose value is tied
to or derived from the value of an underlying asset, financial instrument or
other reference item.
Forward contracts, futures contracts, options and swaps are derivative financial
instruments studied in this text.
We learned that derivatives can serve as hedges or as speculative investments.
Because derivatives can be complex, they may expose the entity to losses not
contemplated by users of financial statements. These users, particularly
investors and creditors seeking to assess risk, should be interested in the
exposure created by derivatives and their purpose--hedging or speculation.
Q11.4
Hedge accounting entails matching the recognition of gains and losses on
derivatives that qualify as hedges with the gains and losses recognized on
hedged items. The objective is to report gains/losses on hedge derivatives and
hedged items in the same period=s earnings. This is done by (1) currently
recognizing value changes in both the hedge and the hedged item (fair value
hedges) or (2) initially recognizing the hedge=s value changes in other
comprehensive income and later releasing these value changes into earnings
when the gains/losses on the hedged items are recognized in earnings (cash
flow hedges). Hedge accounting can be used when:
1.
2.
3.
The item to be hedged exposes the company to price, currency or
interest rate risk.
Hedging is sufficiently effective in reducing the company's
exposure to these risks.
The hedge position is designated as a hedge.
11-7
Q11.5
Futures contracts will reduce risk when the price behavior of the futures
contract correlates positively with the price behavior of the item being hedged.
For example, when hedging an owned asset you would sell futures (go short).
Suppose the price of the owned asset--the hedged item--declines and the
futures price also declines. In this case, the gain realized on closing the futures
position by purchasing futures offsets the loss incurred on the owned asset.
Therefore, when there is negative correlation between the price of the futures
and the price of the hedged item, and when a futures contract is used for
speculative purposes, the use of futures contracts increases the risk of loss.
Q11.6
Fair value hedges are hedges of changes in the fair values of existing assets,
liabilities or firm commitments. Value changes in the hedge derivative and the
hedged item are recognized as offsetting gains and losses in current earnings.
Cash flow hedges are hedges of the cash flows expected from forecasted or
probable anticipated transactions. Value changes in the hedge derivative are
initially reported in other comprehensive income and released to earnings
when the forecasted transaction is recognized and affects earnings.
Q11.7
Options differ from both futures and forward contracts in that the owner of the
option has no obligation to perform. The option's writer does guarantee to
perform, however, and receives a fee (premium) as compensation.
11-8
Q11.8
The writer of an option is said to be covered when the item underlying the
option is owned. The writer is said to be naked when the optioned item is not
owned.
The writer of a covered option is essentially hedged; the limited exposure to
risk consists of any lack of correlation between movements in the prices of the
optioned item and the option. In contrast, the writer of a naked option has
essentially taken a speculative position with unlimited risk. If the option is
exercised, the writer will have to buy or sell the optioned item in the market at
the (presumably unfavorable) prevailing market price.
Q11.9
A put option on bonds is used to hedge against a rise in interest rates. The put
option gives the holder the right to sell the bonds at the strike price. The strike
price on the bonds is expressed as a percentage of par which reflects an interest
yield. When interest rates rise, the bonds' price falls; if it goes below the strike
price, exercise of the put enables the holder to sell the bonds at the (higher)
strike price and avoid the loss created by the rise in interest rates.
Q11.10
The most significant risk assumed by the counterparties in an interest rate swap
is credit risk; namely, that the other party to the swap will not perform.
Counterparties may avoid this risk by engaging an intermediary who will
assume the credit risk for a fee. In many cases collateral is required to protect
against default by the other party.
11-9
Q11.11
In a plain vanilla interest rate swap, one counterparty swaps a floating rate
obligation for a fixed rate obligation and the other counterparty swaps a fixed
rate obligation for a floating rate obligation. The party swapping the floating
rate obligation becomes the fixed rate payer and the party swapping the fixed
rate obligation becomes the floating rate payer.
The principal motivation is to obtain fixed or variable rate financing at a cost
lower than that incurred by borrowing directly. Normally the counterparties
also seek to use swaps to hedge their cash flows. Thus a firm with variable
dollar inflows might swap a fixed interest rate payments for floating rate
interest payments, thereby creating an approximate hedge of the variable
inflows by the variable outflows.
Q11.12
As separate financial instruments, swaps consist of two sets of cash flows. In a
currency swap, one set of cash flows is in foreign currency and the other in
dollars. In an interest rate swap, one set of cash flows is fixed and the other is
variable. The basic valuation principles are:
Currency Swap
Value of currency swap = dollar equivalent of foreign currency flows - dollardenominated flows
In a currency swap, the only component that changes is the dollar equivalent of
the foreign currency flows. Discounting is required for multi-period swaps.
The presence of an asset or liability depends on whether the instrument has a
net debit or credit balance.
For example, when a U.S. company swaps foreign currency for dollars, we
have the equivalent of a forward sale contract. As long as the debit balance of
dollars due from the counterparty under the terms of the swap exceeds the
dollar equivalent of the foreign currency to be transferred to the counterparty,
the entity has an asset called Investment in Forward Contract.
Q11.12 (cont=d.)
11-10
Interest Rate Swap
Value of interest rate swap = PV of fixed rate flows - PV of floating rate
flows
In an interest rate swap, the PV of the fixed rate flows changes as the current
market (discount) rate changes but the PV of the floating rate flows does not.
If the interest (discount) rate goes down, so does the floating interest payment,
and vice versa; the effect of the changed discount rate is offset by the effect of
the changed interest payment and the PV remains unchanged at par or face
value. Again, the presence of an asset or liability depends on whether the
instrument has a debit or credit balance.
For example, the floating rate payer (liability) is the fixed rate receiver (asset).
As long as the "debit balance" of the PV of fixed interest payments exceeds
the (unchanging) PV of the floating interest payments, the entity has an asset
called Investment in Swaps.
Q11.13
Companies= positions in financial instruments were traditionally recognized
only partially or not at all in companies' balance sheets. These instruments
must now be fully recognized and carried at their fair values in the accounts.
SFAS 107 and SFAS 133 aim to provide financial statement users with more
information about a company's positions in financial instruments. Even though
most financial instruments are now carried at fair value, they are often not
reported in financial statements as separate line items. These disclosures help
explain companies uses of derivatives, their fair values and the financial
statement effects of value changes, providing a more complete picture of
financial health and performance. The disclosures should facilitate more
informed assessments of companies' risk profiles.
11-11
SOLUTIONS TO EXERCISES
E11.1 COMMODITY FUTURES (SHORT) ENTRIES, PROFIT
CALCULATION
Requirement 1:
January 6, 20X6
Investment in Futures
10,000
Cash
10,000
To record the initial margin deposit on the sale of commodity futures.
February 19, 20X6
Loss on Hedge Activity
11,000
Cash
11,000
To pay additional cash to the broker to cover the loss of
$11,000 (= $171,000 - $160,000) realized on the decline in
value of the futures contracts.
Inventory
11,000
Gain on Hedge Activity
11,000
To adjust the carrying value of the hedged inventory to fair value.
Cash
10,000
Investment in Futures
10,000
To record receipt of $10,000 from the broker, the initial
deposit which is returned after the futures are closed.
March 2, 20X6
Cash (or Accounts Receivable)
173,500
Sales
173,500
To record sale of commodities.
Cost of Goods Sold
161,000
Inventory
To charge the inventory sold to cost of sales. (Students would
omit this entry if they assumed a periodic inventory system).
11-12
161,000
E11.1 (cont=d.)
Requirement 2:
If Marcelino had not hedged by selling futures short, it would have avoided the
$11,000 loss sustained when the short futures sold for $160,000 were closed
by purchasing an offsetting long contract for $171,000. Marcelino's profit,
which was $12,500 (= $173,500 - $161,000) under the hedge, would therefore
have increased by $11,000 to $23,500 (= $173,500 - $150,000 inventory
acquisition cost) if the hedge was not undertaken.
E11.2 ANALYZING HEDGE EFFECTIVENESS: FUTURES
Requirement 1:
High hedge effectiveness is achieved when, as stated in the problem,
movement in the futures price offsets 110% of the movement in the spot price;
exact 100% offset is not required.
Requirement 2:
Hedge effectiveness measure = change in fair value of hedge instrument
change in fair value of hedged item
Hedge effectiveness measure = ($10.30 - $10.40) X 100,000
($10.50 - $10.35) X 100,000
= ($10,000)/$15,000
= - 67%
The numerator shows the change in the spot price componentCthe hedge
instrument in this caseCwhereas the denominator is the change in the
commitment valued at the futures price. This hedge is no longer highly
effective and hedge accounting is discontinued effective as of the last date high
effectiveness was demonstrated. The futures contract is now a speculative
instrument and the change in fair value of the futures contract is recognized in
earnings. The creation of an offset by revaluing the firm commitment no
longer exists when hedge accounting terminates.
11-13
E11.2 (cont=d.)
Requirement 3:
Since the hedge was last effective at inception, the $15,000 loss on the futures
contract since inception is recognized in current earnings without offset from
revaluing the firm commitment.
NOTE: Even though the spot price component of the futures price was
designated as the hedge instrument, revaluation of the firm commitment is
based on the change in the futures price, not the change in the spot price. Had
the hedge been highly effective, the earnings impact would be zero even
without perfect effectiveness because both the futures contract and the firm
commitment are valued at the futures price.
E11.3 COMMODITY FUTURES (LONG) JOURNAL ENTRIES
Requirement 1:
The long position in the futures contract hedges an existing liability, the
deferred revenue, and serves as a fair value hedge. A value change of $10,000
[= ($11 - $10) 10,000] is realized on June 30, representing a gain on the
futures contracts and a loss on the exposed liability. A further value change of
$5,000 [= ($11.50 - $11) 10,000] is realized on August 29, which also is a gain
on the futures contracts and a loss on the exposed liability. When the
commodities are shipped to the customer, the deferred revenue, which now
includes the total value change (loss) of $15,000, will be recognized as realized
revenue.
June 1, 20X6
Investment in Futures
10,000
Cash
To record the initial margin deposit on the purchase of
commodity futures.
11-14
10,000
E11.3 (cont=d.)
June 30, 20X6
Investment in Futures
10,000
Gain on Hedge Activity
To record the $10,000 [= 10,000 X ($11-$10)] gain on the
long position hedging deferred revenue, an existing liability.
Loss on Hedge Activity
10,000
10,000
Liability (Deferred
Revenue)
To record in earnings the increase in the fair value of the
commodities needed to settle the liability.
August 29, 20X6
Investment in Futures
10,000
5,000
Gain on Hedge Activity
To record the $5,000 [= 10,000 X ($11.50-$11)] gain on the
long position hedging deferred revenue, an existing liability.
Loss on Hedge Activity
5,000
5,000
Liability (Deferred
Revenue)
To record in earnings the increase in the fair value of the
commodities needed to settle the liability.
Cash
5,000
25,000
Investment in Futures
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.
11-15
25,000
E11.3 (cont=d.)
Requirement 2:
Even though Daley intends to purchase the commodity in the spot market, the
purchase of futures locks in the ultimate price paid at $10.00. Daley received
$150,000 from the customer; without hedging any increase in the spot price
reduces Daley's ultimate profit on the transaction. With hedging, if the
commodity's price increases, the gain on the long futures position offsets the
loss created by having to purchase the commodity at that higher price.
Without Hedging:
Cost of commodity at spot price ($11.50 X 10,000)
$115,000
With Hedging:
Spot price paid ($11.50 X 10,000)
Realized gain on futures contract [($11.50 - 10) X 10,000]
Net cost of commodity
Amount saved by hedging
$115,000
(15,000)
$100,000
$ 15,000
E11.4 COMMODITY FUTURES (SHORT) JOURNAL ENTRIES
The short position in the futures contract hedges a firm sale commitment and is
a fair value hedge.
June 1, 20X2
Investment in Futures
10,000
Cash
To record the initial margin deposit of $10,000 paid to the broker.
10,000
June 30, 20X2
On June 30, 20X2, Keister realizes a gain of $20,000 [= ($5 - $4.80) 100,000]
on its short position and a $20,000 loss in value of the firm sale commitment.
11-16
E11.4 (cont=d.)
Investment in Futures
20,000
Gain on Hedge Activity
20,000
To mark the short futures position to market and recognize
the gain in earnings.
Loss on Hedge Activity
20,000
Firm Commitment
20,000
To recognize the loss on the firm sale commitment due to
a decline in selling prices.
August 29, 20X2
A further gain of $5,000 [= ($4.80 - $4.75) 100,000] is realized on the short
futures; it, and the related loss on the firm sale commitment, are recognized.
Investment in Futures
5,000
Gain on Hedge Activity
5,000
To mark the short futures position to market and recognize
the resulting gain.
Loss on Hedge Activity
5,000
Firm Commitment
5,000
To recognize the loss on the firm sale commitment due to
a decline in selling prices.
Commodities Inventory
460,000
Cash
460,000
To record purchase of the commodities.
September 28, 20X2
The futures= loss in value of $2,000 [= $4.77 - $4.75) 100,000] accruing since
August 29 and the offsetting gain on the firm sale commitment are recorded.
Also, the short position is closed out and the $33,000 (= $10,000 + $20,000 +
$5,000 - $2,000) margin deposit is returned by the broker.
11-17
E11.4 (cont=d.)
Loss on Hedge Activity
2,000
Investment in Futures
To mark the futures contract to market.
Firm Commitment
2,000
2,000
Gain on Hedge Activity
To recognize the gain on the firm sale commitment due to
a price increase.
Cash
2,000
33,000
Investment in Futures
To close out the short futures position and recover from the
broker the initial margin deposit of $10,000, increased by
realized gains of $23,000.
33,000
NOTE: When the sale occurs, the firm commitment liability is closed to Sales
Revenue, increasing it by $23,000.
11-18
E11.5 ECONOMICS OF HEDGING WITH FUTURES; HEDGE
ACCOUNTING
Requirement 1.
If McVeigh purchases the commodity for $4 per unit and closes out its long
futures position for $4 per unit, McVeigh incurs a cash loss of $1.50 (= $5.50 $4). Added to the per-unit commodity cost of $4, the $1.50 loss increases the
cost per unit to $5.50.
Similarly, if McVeigh purchases the commodity for $6 per unit and closes out
its long futures position for $6 per unit, McVeigh realizes a cash gain of $.50
(= $6 - $5.50) per unit. Subtracting this $.50 gain from the unit cost of $6
leaves the net cost of the commodity at $5.50 per unit.
Requirement 2:
In this case, McVeigh grows the commodity on its own farms, and may cover
its delivery commitment with its own inventory. However, SFAS 133 requires
only that the futures be designated as a hedge of the purchase commitment.
The existing inventory is irrelevant. (NOTE: Under prior practice the long
futures position is redundant, given the inventory. Hence the long position
would be considered speculative, and hedge accounting would be prohibited.)
11-19
E11.6 ECONOMICS OF HEDGING WITH OPTIONS; HEDGE
ACCOUNTING
Requirement 1:
Call options allow the holder to avoid loss if the price of the optioned item
rises but to realize gain if the price of the optioned item falls (see Panels D, E
and F in Figure 11.2). The cost of accomplishing this is the premium paid for
the options. Purchase of 100,000 calls for $45,000 means that $.45 is added to
the unit cost of the commodities when purchased.
If the commodity is bought in the spot market for $4.00, the option is not
exercised and the option's premium increases the commodity's unit cost to
$4.45. If the commodity's price is $6.00, (a) the options can be exercised and
the commodity purchased at $5.50 or (b) the options can be sold for a gain of
$.50 in intrinsic value, reducing unit cost of the commodity on the spot market
to $5.50 (= $6.00 - $.50). Whichever action is taken, the $.45 premium
increases the cost of the commodity to $5.95 (= $5.50 + $.45).
Requirement 2:
One could argue that an option possesses both a risk-reducing component and
a speculative component. The upward sloping diagonal line in the upper-right
hand quadrant of Panel D in Figure 11.2 provides the risk reduction by
offsetting the corresponding loss in Panel E. The horizontal line to the left of
the origin in Panel D--viewed as the speculative component--has no effect on
the profit potential on the underlying exposure shown in the upper right-hand
quadrant of Panel E. Thus a purist might argue against hedge accounting for
options because of the inherent profit potential in the underlying exposure
when the price of the optioned item falls (calls) or rises (puts).
This concern has not invalidated the use of hedge accounting as long as the
options provides protection against loss and qualify as hedges. The premium
paid further signifies the insurance aspect of options.
11-20
E11.7 INTEREST RATE CAP: JOURNAL ENTRIES
July 2, 20X1
Investment in Interest Rate Cap
18,000
Cash
To record premium paid on 7.1% interest rate cap payable
in full immediately; $18,000 = $3,000,000 X 0.003 X 2.
December 31, 20X1
Interest Expense
18,000
105,000
Interest Payable
To record interest payable on the loan for the first six months;
$105,000 = $3,000,000 X .07 X .5.
Loss on Options
105,000
11,000
Investment in Interest Rate Cap
To recognize the decline in fair value of the time value
portion of the premium; $11,000 = $18,000 - $7,000. The
cap remains out of the money and still has no intrinsic value.
11,000
June 30, 20X2
Interest Expense
109,500
Interest Payable
109,500
To record interest payable on the loan for the year;
$109,500 = $3,000,000 X .073 X .5.
Investment in Interest Rate Cap
Loss on Options
1,000
2,000
Interest Expense
To record the $1,000 increase in fair value of the interest
rate cap. The cap goes in the money by $3,000
[= $3,000,000 X (.073 - .071) x .5] but loses $2,000 of its
time value; $2,000 = $18,000 - $11,000 - $5,000. NOTE:
The $3,000 increase in intrinsic value (gain) reduces interest
expense to $106,500 (= .5 x .071 x $3,000,000 = $109,500 - $3,000)
and the $2,000 decrease in time value is a loss.
E11.7 (cont=d.)
11-21
3,000
Cash
3,000
Investment in Interest Rate Cap
To record collection of the excess interest due under the
interest rate cap agreement.
3,000
E11.8 PUT OPTIONS: JOURNAL ENTRIES
March 1, 20X1
Investment in Options
6,200
Cash
To record purchase of put options; $6,200 = 2,000 X $3.10.
June 30, 20X1
Loss on Hedge Activity
6,200
3,600
Investment in Options
To record the loss on options hedging an investment in
government bonds; ($3,600) = 2,000 ($1.30 - $3.10).
Investment in Bonds
3,600
4,000
Gain on Hedge Activity
To adjust carrying value of the bond investment by the
increase in intrinsic value and report the offsetting gain in
earnings; $4,000 = (1.00 - 0.98) X $200,000.
.
December 31, 20X1
Investment in Options
Gain on Hedge Activity
To record the gain on options hedging an investment in
government bonds; $6,000 = 2,000 X ($4.30 - 1.30).
11-22
4,000
6,000
6,000
E11.8 (cont=d.)
Loss on Hedge Activity
6,000
Investment in Bonds
To adjust the investment in bonds to its current fair value;
$6,000 = (.97 - 1.00) X $200,000.
6,000
Cash
8,600
Investment in Options
To record the sale of put options; $8,600 = 2,000 X $4.30
= $6,200 - $3,600 + $6,000.
8,600
Alternate Entry to Record Sale of Options
Cash
8,600
Investment in Options
Gain on Hedge Activity
To record sale of put options; carrying amount prior to
revaluation at December 31, 20X1 is $2,600 (= $6,200 - $3,600).
2,600
6,000
E11.9 CURRENCY CALLS: JOURNAL ENTRIES, HEDGE
EFFECTIVENESS
Requirement 1:
July 1, 20X1
Investment in Options
28,000
Cash
To record purchase of call options; $28,000 = 2,000,000 X $.014.
December 31, 20X1
Investment in Options
28,000
110,000
Gain on Hedge Activity
To record gain on foreign currency call options hedging
,2,000,000 note payable; $110,000 = ($.069 - .014) X 2,000,000.
11-23
110,000
E11.9 (cont=d.)
Loss on Hedge Activity
100,000
Loan Payable
To accrue transaction loss on loan payable;
$100,000 = ($1.55 - $1.50) X 2,000,000.
June 30, 20X2
Investment in Options
100,000
102,000
Gain on Hedge Activity
To record gain on foreign currency call options hedging
,2,000,000 note payable; $102,000 = ($.12 - $.069) X 2,000,000.
Loss on Hedge Activity
102,000
120,000
Loan Payable
To accrue transaction loss on loan payable; $120,000 =
($1.61 - $1.55) X 2,000,000.
Cash
120,000
240,000
Investment in Options
To record the sale of put options; $240,000 = 2,000,000
X $.012 = $28,000 + $110,000 + $102,000.
240,000
Alternate Entry to Record Sale of Options
Cash
240,000
Investment in Options
138,000
Gain on Hedge Activity
102,000
To record sale of put options; carrying amount prior to
revaluation at June 30, 20X2 is $138,000 = $28,000 + $110,000.
11-24
E11.9 (cont=d.)
Requirement 2:
Hedge effectiveness measure = change in fair value of hedge instrument
change in fair value of hedged item
At December 31, 20X1, the hedge effectiveness measure is - 1.1
[= $110,000/($100,000)], indicating high effectiveness.
At June 30, 20X2, the hedge effectiveness measure is -.85
[= $102,000/($120,000)], indicating continuing high hedge effectiveness.
NOTE: Technically hedge accounting does not apply here, as foreigncurrency- denominated obligations are automatically restated to fair value
under SFAS 52.
E11.10
ANALYZING HEDGE EFFECTIVENESS: OPTIONS
Requirement 1:
Historic information that the change in intrinsic value of the hedge instrument
correlates with .95 of the change in the commodity=s spot price indicates high
hedge effectiveness at inception.
Requirement 2:
Hedge effectiveness measure = change in fair value of hedge instrument
change in fair value of hedged item
= $30,000 (intrinsic value only)
-($2.027 - $2) X 1,000,000
= $30,000/($27,000) = -1.11
Thus the high hedge effectiveness test continues to be met.
11-25
E11.10 (cont=d.)
NOTE: at inception the options are at the money and the total $60,000
premium is time value. On September 30 the premium declined by $5,000 (=
$55,000 - $60,000) consisting of a $30,000 increase in intrinsic value (from
$0) and a $35,000 decrease in time value [($55,000 - $30,000) - $60,000].
Requirement 3:
Income Statement:
Loss on Options ($35,000 - $30,000)
Loss on Firm Commitment Liability
Net Loss
$ 5,000
27,000
$32,000
Equivalently, there is a $35,000 loss on the time value (non-hedge) component
of the options= value, a $30,000 gain on the intrinsic value (hedge) component
and a $27,000 loss due to the increase in the fair value of the firm commitment
liability. The $32,000 net loss can also be viewed as the $35,000 reduced by
the $3,000 (= $30,000 - $27,000) gain on the ineffective portion of the hedge.
Balance Sheet:
Investment in Options
Firm Commitment
Retained Earnings
Cash (reduced by $60,000 premium paid)
11-26
Dr. (Cr.)
$55,000
(27,000)
32,000
(60,000)
E11.11
INTERPRETING FINANCIAL INSTRUMENT
DISCLOSURES
Requirement 1:
Pay-floating swaps are receive-fixed swaps. These are (a) fair value hedges
and (b) their value changes enter current earnings, presumably offset by the
value change in the fixed-rate debt they are hedging.
Pay-fixed swaps are receive-floating swaps. These are (a) cash flow hedges
and (b) their value changes initially enter other comprehensive income. Later,
as the future variable interest payments on the hedged floating-rate debt are
made, portions of the value change are reclassified into earnings to offset the
changes in those payments.
Interest rate caps are options. These are (a) cash flow hedges against rising
interest payments on floating-rate debt and (b) their value changes enter
current earnings. Increases in intrinsic value occur when the interest rate rises
above the rate specified in the cap and are credited to the (higher) interest
expense. Changes in the time value enter earnings through interest expense or
an Aother@ expense.
Requirement 2:
Above the second tabular display Disney notes that Athe company uses option
strategies that provide for the sale of foreign currencies to hedge probable, but
not firmly committed, revenues.@ Thus these are foreign currency puts,
options to sell foreign currencies for dollars. In the third tabular display we
see that foreign exchange options have a positive (asset) fair value of $39
million at September 30, 2000, higher than their carrying amount. These will
rise in value as the dollar price of the foreign currenciesCthe direct exchange
rateCfalls. Apparently the optioned currencies weakened and the indirect
rateCforeign currency price of dollarsCincreased.
11-27
E11.12
BENEFITS OF INTEREST RATE SWAP
Advantage to Apricot, Inc.:
Inflows: floating rate from Nectar
LIBOR + 30 8.3%
Outflows: fixed rate to Nectar
9.5%
floating rate on debt
LIBOR + 30 8.3%
Total outflows:
17.8%
Actual fixed interest cost with swap
9.5%
Alternative financing: fixed rate on new debt
11.0%
Advantage due to swap
1.5%
Advantage to Pear, Inc.:
Inflows: fixed rate from Nectar
Outflows: fixed rate on debt
floating rate to Nectar
LIBOR + 50 8.5%
Total outflows
Actual floating interest with swap
Alternative financing: fixed rate on existing debt
Advantage due to swap
17.7%
8.5%
9.2%
0.7%
Spread to Nectar Interbank:
Inflows: fixed rate from Apricot, Inc.
floating rate from Pear, Inc.
Total Inflows
Outflows: floating rate to Apricot, Inc.
fixed rate to Pear, Inc.
Total Outflows
Net interest rate spread
9.5%
8.5%
18.0%
8.3%
9.2%
17.5%
0.5%
11-28
LIBOR + 50
LIBOR + 30
9.2%
9.2%
E11.13
INTEREST RATE SWAP: PROFIT AND DEFAULT
Requirement 1:
Meno Bank'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 6.5%
6.6%
6.4%
13.0%
6.3%
12.8%
0.2%
With a .2% net spread, Meno Bank was earning $2,000 (= .002 X $1,000,000)
a year or approximately $167 a month.
Requirement 2:
Meno Bank receives T + 40 from Prince, the equivalent of 6.4% when T = 6%,
while it is paying LIBOR + 20, the equivalent of 6.5% when LIBOR = 6.3%.
Thus the money the bank was making was derived from its arrangements with
Queen - not Prince. When LIBOR increases by 20bp, the floating rate rises to
6.7% (= LIBOR of 6.3% + 20 + 20) and the bank's loss on the arrangement
with Prince increases to 0.3% (= 6.7% - 6.4%). After Queen's default, Meno
Bank is losing $3,000 a year or $250 a month; $250 = (.003 X 1,000,000)/12.
11-29
E11.14
INTEREST RATE SWAP: JOURNAL ENTRIES
This is a plain vanilla swap. Under SFAS 133 Queen has a fair value hedge
because it receives fixed from the bank and pays variable to the bank. In
contrast, Prince has a cash flow hedge because it receives variable from the
bank and pays fixed to the bank.
September 30, 20X8
Queen Corp.
Interest Expense
750
Cash
To record net cash payment made to Meno Bank;
($750) = [(.063 - .066) X $1,000,000]/4.
Loss on Hedge Activity
750
75,000
Investment in Swaps (or
Swap Liability)
To mark to market interest rate swap serving as a fair value
hedge; unrealized loss affects earnings.
Prince, Inc.
Cash
75,000
250
Interest Expense
To record net cash received from Meno Bank;
$250 = [(.065 - .064) X $1,000,000]/4.
Investment in Swaps
250
33,000
Other Comprehensive Income
33,000
To mark to market interest rate swap serving as a cash flow hedge; unrealized
gain entered in other comprehensive income.
11-30
E11.14 (cont=d.)
Meno Bank
Cash
500
Gain on Swaps
To record net gain on the swap from 7/1/X8 to 9/30/X8;
$500 = $750 - $250.
Investment in Swaps
500
42,000
Gain on Swaps
To mark to market the bank=s net swap position and
record the gain in earnings.
E11.15
42,000
INTEREST RATE SWAP: JOURNAL ENTRIES
Requirement 1:
January 1, 20X0
Cash
10,000,000
Note Payable
To record issue of a note payable for cash.
(The interest rate swap has no value at inception.)
June 30, 20X0
Interest Expense
10,000,000
450,000
Cash
To record interest for the first six months;
$450,000 = .09 X $10,000,000/2.
Cash
450,000
35,000
Interest Expense
To record net cash payment from counterparty to swap;
$35,000 = (.09 - .083) X $10,000,000/2; .083 = .077
(average LIBOR) + 60 bp.
11-31
35,000
E11.15 (cont=d.)
Investment in Swaps
275,000
Gain on Hedge Activity
To record the change in fair value of the swap as an asset
(decline in market interest rate increases the present value
of the 9% fixed payments received from counterparty.
Loss on Hedge Activity
275,000
275,000
Note Payable
To mark the hedged debt to market.
275,000
Requirement 2:
The swap in 1. is a fair value hedge (receive fixed/pay variable) and value
changes are reported in earnings. In 2., however, Marshall is hedging the
variable interest payments on its variable rate debt and has a cash flow hedge
(receive variable/pay fixed). Value changes on cash flow hedges are reported
in other comprehensive income. Moreover, the present value of Marshall=s
fixed payment obligation rises when interest rates fall so that Marshall=s new
swap becomes a liability, not an asset.
In sum, Marshall recognizes a liability for the swap and the related loss is
entered in other comprehensive income.
11-32
SOLUTIONS TO PROBLEMS
P11.1 COMMODITY FUTURES (SHORT) ENTRIES, GAIN/LOSS
CALCULATIONS
Requirement 1:
August 1, 20X5
Investment in Futures
75,000
Cash
To record the initial margin deposit of $75,000 paid to the broker.
75,000
September 30, 20X5
On September 30, Davis has realized a loss of $40,000 [= (10,000 ($167 $163)] as the cost of closing out the short position has increased. The loss is
realized because additional cash must be deposited with the broker and the
entry is as follows:
Loss on Hedge Activity
40,000
Cash (or Investment in
Futures)
To record the additional margin deposit due to the price
movement adverse to a short position. Because this is a
fair value hedge, the loss is recognized currently in income.
Inventory (Soybean
Meal)
40,000
40,000
Gain on Hedge Activity
To recognize the value change in the inventory.
40,000
October 28, 20X5
When Davis closes out the short position on October 28, it recoups its earlier
loss of $40,000 and nets a gain of $2 (= $163 - $161) per ton, or $20,000. The
entries to record closing out the short position appear below. Cash received
from the broker includes the $75,000 margin deposit made on August 1.
11-33
P11.1 (cont=d.)
Investment in Futures
60,000
Gain on Hedge Activity
To record the gain on the short futures position caused by
the decline in the futures price; $60,000 = ($161 - $167) X 10,000.
Loss on Hedge Activity
60,000
60,000
Inventory (Soybean Meal)
To recognize the value change in the inventory.
Cash
60,000
135,000
Investment in Futures
To record closing the short position and settling with the broker.
The broker returned cash of $135,000 (= $75,000 + $60,000).
135,000
NOTE: If the $40,000 to cover the loss on September 30 was credited to
Investment in Futures, the cash returned and the balance in Investment in
Futures is only $95,000 (= $75,000 - $40,000 + $60,000).
Requirement 2:
When Davis sells the soybean meal in the spot market, it realizes a gain of
$405,000 {= [$148.50 - ($110 + $4 - $6)] x 10,000}. This gain may be
analyzed as follows.
Gain on sale, ignoring the hedge [10,000 ($148.50 - $110)]
Net gain on the hedge [10,000 ($6 - $4)]
Net Gain
11-34
$385,000
20,000
$405,000
P11.1 (cont=d.)
OR
Gain on sale assuming delivery pursuant to futures contract
[($163 - $110) 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
[($163.00 - $148.50) X 10,000]
Net Gain
$530,000
20,000
(145,000)
$405,000
Requirement 3:
Had Davis purchased (rather than sold) the futures for $163, later closing out
this position by selling futures for $161, a $20,000 [= ($161 - $163) X 10,000]
net cash loss is sustained.
Because Davis already owns the soybean meal inventory, and does not have a
firm commitment to fulfill, purchase of soybean meal futures is either
speculative or, if the futures purchase is hedging an anticipated transaction, a
cash flow hedge. The accounting treatments of the short gain and the long loss
are described next.
Short Gain: Because the sale of futures qualifies as a fair value hedge in this
problem, the net $20,000 short gain in 1. enters earnings but is offset by the
value change in the hedged inventory.
Long Loss: If the purchase of futures is speculative, the $20,000 net loss on the
futures is recognized in earnings when realized. But if the futures purchase
qualifies as a cash flow hedge, the $20,000 net loss is first accumulated in
other comprehensive income and later released to earnings when the hedged
anticipated transaction impacts earnings.
11-35
P11.2 INTEREST RATE FUTURES ENTRIES AND ANALYSIS
Requirement 1:
The long position in Treasury bill futures hedges the anticipated roll-over of
Greenstein's short-term Treasury bill investments, serving as a cash flow
hedge. On June 30, Greenstein realizes a gain of $2,500 [= (.91 - .90)
$1,000,000/4], entering it in other comprehensive income pending completion
of the roll-over. A further gain of $1,250 [= (.915 -.91) $1,000,000/4],
realized on August 30, enters other comprehensive income. The $3,750 total
is reclassified from other comprehensive income to earnings over time after the
new bills are purchased. It has the same effect as a discount that reduces the
cost of the new Treasury bills and is subsequently amortized to income as part
of interest revenue.
June 1
Investment in Futures
10,000
Cash
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 other comprehensive income.
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 other comprehensive income.
11-36
1,250
P11.2 (cont=d.)
Cash
Investment in Treasury
Bills (new)
21,250*
978,750
Investment in
Treasury Bills (old)
To record the roll-over of the investment in the Treasury bills.
Cash
1,000,000
13,750
Investment in Futures
To record receipt of the margin deposit from the broker
($13,750 = $10,000 + $2,500 + $1,250).
13,750
As interest revenue on the new Treasury bills is recorded, it will be augmented
by a pro-rata share of the $3,750 gain released from other comprehensive
income.
*Cash received from redemption of old securities
$1,000,000
Cost of new securities: $1,000,000 -[$1,000,000 X (.085/4)]
(978,750)
Net cash received
$ 21,250
Requirement 2:
The cost of the new Treasury bills is $978,750, which reflects the current 8.5%
annual discount yield (2.125% quarterly).
$978,750 = $1,000,000 - ($1,000,000 X .02125)
However, the $3,750 cash gain on the futures contracts currently in other
comprehensive income will increase interest income by $3,750 over the 91-day
term of the new Treasury bills. Thus the total return on the new Treasury bills
is $25,000 (= $21,250 + $3,750), which reflects a 10% annual discount yield
(2.5% quarterly); $25,000 = .025 X $1,000,000.
11-37
P11.3 INTEREST RATE FUTURES: FAIR VALUE HEDGE
Requirement 1:
At 90, each $1,000 bond has a value of $900 and futures contracts for 1,000
bonds [= (300,000 X $3)/900)] would be sold to protect the value of Petren's
own bonds that ultimately will be sold to pay for the fabric. The face value of
these bonds is $1,000,000 (= 1,000 X $1,000). This sale of futures at 90
produces a realized loss of ($20,000) [= (.90 - .92) X $1,000,000] when the
futures contract is closed out (by purchasing futures at 92). The $20,000 loss
offsets the $20,000 [= (.92 - .90) X $1,000,000] realized gain on Petren's
bonds due to their increase in value before being sold to pay for the fabric.
Petren could report both the $20,000 gain and offsetting $20,000 loss but will
likely net them out. Thus the net result of this hedge is no gain or loss and no
effect on earnings.
Notes to Instructor:
(1) Some students may believe that other comprehensive income should come
into play here. Whereas unrealized value changes in available-for-sale (AFS)
securities are normally accumulated in other comprehensive income per SFAS
115, when AFS securities are hedged by a derivative, SFAS 133 requires that
the AFS value change be reported in earnings to offset the derivative=s value
change. A careful reading of Requirement 1 indicates that the value changes
are realized. The value changes in Requirement 2, though, are unrealized.
(2) Some students may interpret this as a cash flow hedge of the anticipated
sale of the bonds, an interpretation that is consistent with SFAS 133, and raise
the prospect of other comprehensive income in this context. However, the
intent of this problem is that the futures are hedging the fair value of the bonds
held, not the forecast sale of the bonds. Paragraph 411 (a) of SFAS 133
indicates that an entity could designate the futures as either a fair value hedge
of the bonds= value or a cash flow hedge of the uncertain cash flow from
anticipated sale of the bonds.
P11.3 (cont=d)
11-38
Requirement 2:
At any intervening balance sheet date, the futures are revalued to fair value
along with the AFS bonds, the hedged item. An unrealized loss is recognized
on the short futures as it now costs 91.5 to enter an offsetting long contract to
settle the short contract sold at 90. This loss is offset by an unrealized gain on
the bonds which increased in value from 90 to 91.5. Both loss and gain are
recognized in earnings.
Loss on Hedge Activity
15,000
Investment in Futures
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 Hedge Activity
To record unrealized gain on AFS bonds;
$15,000 = (.915 - .90) X $1,000,000.
15,000
Requirement 3:
To hedge the value of its AFS bonds, Petren has to sell Treasury bond futures.
If Petren buys Treasury bond futures, it no longer has an exposure to hedge
and now has a speculative futures investment. Thus the purchase of futures
described in the problem does not qualify as a hedge.
Requirement 4:
Here futures are purchased at 90. If sold at 93, the futures produce a realized
gain of $30,000 [= (.93 -.90) X $1,000,000]. The bonds sold from Petren's
own portfolio also produce a gain of $30,000 for a total gain of $60,000 that is
recognized in current earnings.
11-39
P11.4 EVALUATING HEDGING WITH FUTURES CONTRACTS
Requirement 1:
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.
Requirement 2:
If the commodities are hedged with futures contracts, 1,000,000 bushels will
be worth $4,750,000 when harvested in six months. However, interest of
$8,000 (= .5 X .08 X 200,000) on the margin deposit is foregone. Thus in six
months the net proceeds from, or value of, the commodities is $4,742,000 (=
$4,750,000 - $8,000), implying that $4.742 per bushel is the price at which the
company is indifferent.
At a spot price below $4.742, hedging dominates not hedging. If the price
exceeds $4.742, not hedging dominates.
11-40
P11.4 (cont=d.)
Requirement 3:
Cash
Inventory
Gain on Growing
Crops
Financial Statement Effects Dr. (Cr.)
(1)
(2)
Hedge with
No Hedge
Futures Contracts
$ 8,000
$ (500,000) (1)
5,250,000 (2)
5,250,000 (2)
(5,250,000)
(3)=(1)-(2)
Difference
$ 508,000
C
(5,250,000)
C
Loss on Futures
C
Contracts
500,000 (1)
(500,000)
C
Interest Income
(8,000)
(8,000)
(1) Reflects $500,000 [= (4.75 - 5.25)1,000,000] loss on futures contracts.
(2) Carried at market; $5.25 X 1,000,000.
P11.5 EVALUATING HEDGING WITH OPTION CONTRACTS
Requirement 1:
Advantages of hedging with option contracts include:
#
#
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).
11-41
P11.5 (cont=d.)
Requirement 2:
If the commodities are hedged with option contracts and the options are
exercised or in the money at expiration, 1,000,000 bushels will be worth a net
of $4,650,000 [= ($5 X 1,000,000) - $350,000]. Thus at a $4.65 spot price the
company is indifferent. For spot prices below $4.65, hedging dominates not
hedging. For spot prices above $4.65, not hedging dominates hedging.
Lost interest is ignored in the options case because the $350,000 cash paid for
the options is gone permanently; $350,000 is the present value of interest and
principal repayment foregone. In the futures case, the margin deposit caused
temporary nonuse of the cash--the cash received when the margin deposit is
returned has a lower present value than the cash originally deposited. The lost
interest approximates this reduction in present value.
Requirement 3:
Financial Statement Differences Dr. (Cr.)
(1)
(2)
(3)=(1)-(2)
Hedge with
No Hedge
Option Contracts Difference
C
Cash
$ (100,000) (1)
$100,000
C
Inventory
4,750,000 (2)
4,750,000 (2)
Gain on Growing Crops
C
Gain on Growing Crops
(4750,000)
(4,750,000)
C
Net Loss on Options
100,000 (1)
(100,000)
(1) ($100,000) = $250,000 [= ($5.00 - $4.75) X 1,000,000] cash gain on
puts - $350,000 premium.
(2) Carried at market; $4.75 X 1,000,000.
11-42
P11.6 SHORT ANSWER: CURRENCY OPTIONS
Requirement 1:
The strategy of purchasing call options on pounds can be understood by
referring to to Panels D, E and F of Figure 11.2. Panel E is the exposed
liability--the dollar cost of supplying pounds--with the rising dollar cost of
pounds to the right of the origin. The Panel E exposure can be hedged by
purchasing call options to buy pounds for dollars.
The strategy of purchasing put options on dollars can be understood by
referring to Panels A, B and C of Figure 11.2. One way of getting the British
pounds needed is to sell dollars for pounds. Here our stock of dollars, an asset,
represents the exposure. A decline in the pound price of dollars occurs when
the dollar depreciates--to the left of the origin in Panel B--and can be hedged
by purchasing put options to sell dollars for pounds (Panel B). (NOTE: a
decline in the pound price of dollars is equivalent to Athe rising dollar cost of
pounds@ as expressed above.)
Requirement 2:
Again the dollar cost of purchasing pounds is the exposure (Panel E in Figure
11.2). The strategy of buying calls and writing puts on pounds with the same
exercise price creates a synthetic long futures contract which hedges the
exposure as shown in Panels D, E and F of Figure 11.3. The net premium paid
(received) is the cost (benefit) from adopting this strategy as opposed to simply
purchasing futures (Panel A in Figure 11.1)
Requirement 3:
Despite the way the problem is worded, the U. S. construction company=s
exposure is denominated in euros and is shown in Panel E of Figure 11.2.
Thus the hedge will be accomplished by purchasing call options to buy euros
as shown in Panel D. Then if the dollar cost of euros rises (to the right of the
origin), the calls go in the money and the gain in Panel D offsets the loss in
Panel E, an effective hedge.
P11.6 (cont=d.)
11-43
Requirement 4:
The bank wishes to protect the dollar equivalent of the euro-denominated
interest, the exposure depicted in Panel B of Figure 11.2. If a call to purchase
euros with dollars is written (Panel D of Figure 11.2) and the dollar
strengthens (to the left of the origin), the call is out of the money and expires
unexercised. The premium received, however, increases the bank's net return.
If the dollar weakens, the gain on the euro-denominated interest (to the right of
the origin in Panel B) will be offset by the loss on the written call (to the right
of the origin in Panel D).
Another strategy is to purchase puts to sell pounds for dollars (Panel A of
Figure 11.2). If the dollar strengthens, the put goes in the money and the gain
thereon offsets the loss incurred when converting the interest back into dollars.
Requirement 5:
By not hedging, the U.S. company loses $.02 (= $1.45 - $1.43) per euro. With
the calls, the $.02 gain on each call negates the $.02 transaction loss on the
interest. However, the $.03125 premium paid is all time value which,
assuming the calls expire when the interest is due, is a loss that increases the
company's financing cost by more than the $.02 loss from not hedging.
11-44
P11.7 PRESENT VALUE ANALYSIS OF INTEREST RATE CAP
Requirement 1:
This is a straight capital budgeting problem in which the $400,000 outlay for
the cap is compared with the present value of the interest savings under the
assumed prime rates. Savings begin on July 1, 20X7 [$100,000 = (.10 - .09) X
$10,000,000] and increase in each of the two years beginning on July 1, 20X8
[$300,000 = (.12 - .09) X 10,000,000]. These savings are realized at the end of
each fiscal year when the interest is due and the bank settles up.
PV of savings = $100,000/(1.10)2 + $300,000/(1.12)3 +
$300,000/(1.12)4
= $82,645 + $213,534 + $190,655
= $486,834
Since $486,834 > $400,000, purchase of the cap is a good economic decision if
the prime rate increases as expected.
Requirement 2:
A similar approach is used here except that savings are based on comparing the
new lower 6% prime rate with the original 8% [$200,000 = (.08 - .06) X
10,000,000].
PV of savings = $200,000/(1.06)2 + $200,000/(1.06)3 +
$200,000/(1.06)4
= $177,999 + $167,924 + $158,419
= $504,342
Since $504,342 > $400,000, the projected interest savings more than offset the
cost of the cap. Given the assumptions in Requirements 1 and 2, the cap
hedges the potential loss from higher interest rates and the potential savings
from lower interest rates hedge the cost of the cap.
11-45
P11.7 (cont=d.)
Requirement 3:
December 31, 20X7
Interest Expense
500,000
Interest Payable
To record interest on the loan accrued since 6/30/X7;
$500,000 = (.10 X $10,000,000)/2.
500,000
Investment in Interest Rate Cap
50,000
Interest Expense
To record the gain on the cap and reduce interest expense
accordingly; $50,000 = [(.10 - .09) X 10,000,000]/2.
Loss on Options
50,000
50,000
Investment in Interest Rate Cap
To recognize the decline in fair value of the total $400,000
time value premium for four years at the rate of $50,000 (1/8)
per six-month period.
Alternate Entry
Loss on Options
50,000
Interest Expense
June 30, 20X8
Interest Expense
50,000
50,000
500,000
Interest Payable
To record interest on the loan accrued since 12/31/X7.
Interest Payable
500,000
1,000,000
Cash
To pay interest accrued since 6/30/X7.
11-46
1,000,000
P11.7 (cont=d.)
Investment in Interest Rate Cap
50,000
Interest Expense
50,000
To reduce the gain on the cap and reduce interest expense accordingly.
Cash
100,000
Investment in Interest Rate Cap
To record collection of one year's excess interest due under
the interest rate cap.
Loss on Options
100,000
50,000
Investment in Interest Rate Cap
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.
50,000
P11.8 HEDGING EXPOSED ASSETS WITH PUT OPTIONS
Requirement 1:
November 1, 20X5
Other Comprehensive
Income
20,000
Short-Term Investments
To revalue the short-term investments to market value;
the decline in value from $40 to $38 per share enters
other comprehensive income because the investments
are unhedged during this period.
Investment in Options
20,000
35,000
Cash
To record purchase of 10,000 put options.
11-47
35,000
P11.8 (cont=d.)
Because the strike price is $40 and the shares are selling for $38, each put
option is in the money by $2, a total of $20,000 (= 10,000 X $2). The time
value is therefore $15,000 (= $35,000 - $20,000).
December 31, 20X5
Investment in Options
25,000
Gain on Hedge Activity
To mark the intrinsic value of the options to market;
$25,000 = 10,000 ($38 - $35.50).
Loss on Hedge Activity
25,000
25,000
Short-Term Investments
To mark the hedged securities to market. Note: Students
may also recognize the 11/1/X5 pre-hedge revaluation here.
Loss on Options
25,000
10,000
Investment in Options
To recognize assumed 2/3 (= 60/90) reduction in fair
value of the original $15,000 time value.
10,000
NOTE: As the price of the optioned item declines below the strike price, puts
go further into the money and their intrinsic value increases.
Requirement 2:
Proceeds from sale of securities (10,000 X $32)
Proceeds from sale of put options [10,000 ($40 - $32)]
Total proceeds
Cost of securities
Cost of put options
Total cost
Net cash loss
$320,000
80,000
$400,000
$400,000
35,000
$435,000
$ (35,000)
NOTE: Because the options are sold on their expiration date, their premium no
longer includes any time value and the proceeds consist only of intrinsic value.
P11.8 (cont=d.)
11-48
Requirement 3:
20X5: The intrinsic value of the put options serves as a hedge of AFS
securities carried at market and changes in the puts' intrinsic value are
recognized in income. Because value changes of hedged AFS securities are
also recognized in income under SFAS 133, the value changes in the options=
intrinsic value and the AFS securities offset and have no net effect; 20X5
income is reduced only by the assumed $10,000 decrease in the fair value of
the time value component.
20X6: Once the securities and options are sold, all unrealized gains and losses
accumulated in other comprehensive income during unhedged periods are
released to earnings. Requirement 1 indicates a net unrealized loss of $20,000
in other comprehensive income. This loss is now realized and, coupled with
the $5,000 remaining time value that is zero at expiration, 20X6 income is
reduced by $25,000.
P11.9 STRADDLE: JOURNAL ENTRIES AND PROFIT
CALCULATION
Requirement 1:
January 31, 20X4
Cash
25,500
Options Written (Calls)
Options Written (Puts)
To record straddle written on 5,000 shares of Montclair
Corp. stock when puts sold for $3.10 and calls for $2.
February 28, 20X4
Options Written (Calls)
Loss on Options
10,000
15,500
10,000
11,000
Cash
To record closing out calls written by purchasing 5,000
calls for $4.20 each, a total of $21,000.
P11.9 (cont=d.)
11-49
21,000
Options Written (Puts)
11,500
Gain on Options
To mark the outstanding written puts to market and
recognize the unrealized gain (the cost to close out the
puts and remove the related obligation has fallen);
$11,500 = ($3.10 - $.80) X 5,000.
March 31, 20X4
Options Written (Puts)
11,500
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.
4,000
Requirement 2:
Suavo made $4,500 on the straddle; $25,500 in premiums were received when
the straddle was written and $21,000 was paid when the calls were closed out.
11-50
P11.10
ECONOMICS OF INTEREST RATE SWAPS
Requirement 1:
Fixed Rate
9.0%
8.7%
.3%
Axle Co.*
Boda Co.**
Differential
Floating Rate
LIBOR + 90bp
LIBOR + 130bp
(40bp)
Here B has the advantage in fixed rate financing whereas A has the advantage
in floating rate financing. This is the classic swap illustration: A takes B's
lower floating rate financing and becomes the floating rate payer. Negotiation
is not needed here as it is in Requirements 2 and 3.
Requirement 2:
Fixed Rate
8.0%
8.2%
(.2%)
Cino Co.*
Dana**
Differential
Floating Rate
LIBOR + 30bp
LIBOR + 80bp
(50bp)
Here C has the advantage in both fixed and variable financing. Because C has
the greater advantage in floating rate financing, it can "afford" to swap the
much lower floating financing in exchange for D's slightly higher fixed rate
financing. However, to induce C to do so, D must increase the rate paid to C
by, say, 30bp. If so, C winds up being the fixed rate payer at 7.9% (= 8.2% 30bp) and D is the floating rate payer at LIBOR + 60bp (= 30bp + 30bp). This
is exactly like the situation illustrated in the problem.
11-51
P11.10 (cont=d.)
Requirement 3:
Fixed Rate
9.5%
9.3%
.2%
Eske Co.***
Fox Co.***
Differential
Floating Rate
LIBOR + 40bp
LIBOR + 20bp
20bp
Because neither party has an absolute or relative advantage in fixed or floating
rate financing, there is no basis for an exchange beneficial to both parties.
Requirement 4:
Fixed Rate
7.8%
7.3%
.5%
Gary Co.*
Hawk Co.**
Differential
Floating Rate
LIBOR + 70bp
LIBOR + 30bp
40bp
Here H has the advantage in both fixed and floating rate financing. Although
there is little room for negotiation, H will swap its fixed rate financing for G's
floating rate financing. H will pay an additional amount, say 45bp, to G. In
sum, G becomes the fixed rate payer at 7.75% (= 7.3% + 45bp) and H becomes
the floating rate payer at LIBOR + 25bp (= 70bp - 45bp).
* Fixed rate payer
** Floating rate payer
*** No swap occurs as neither party has a relative advantage.
11-52
P11.11
EVALUATE STRATEGIES TO HEDGE AGAINST RISING
INTEREST RATES
Requirement 1:
The swap converts the variable LIBOR + 80 bp rate to a fixed 7% rate. If
LIBOR stays at 6%, Guerard will pay 20 extra basis points in interest each
year under the swap, a total of $400,000 (=.002 x $100,000,000 x 2). In these
circumstances payment of $400,000 for the 7% cap, which will not go in the
money, should make Guerard indifferent between the swap and the cap.
Requirement 2:
If LIBOR is allowed to vary, the problem is much more complicated and in
some sense depends on Guerard=s ability to predict movements in LIBOR
better than its potential counterparties. If LIBOR rises above 6.2%, the swap
protects Guerard at no cost, whereas the cap provides the protection at a cost.
But if LIBOR falls, Guerard is exposed to considerable variable opportunity
losses under the swap whereas the cap=s cost is fixed and there is no return
from it. In general, risk aversion seems to favor the cap that has a fixed known
cost. Greater tolerance for risk favors the swap as long as increases in LIBOR
are likely and the opportunity losses incurred when LIBOR falls are viewed as
real cash payments.
Requirement 3:
If the futures are to hedge against rising interest rates, they should be sold. If
Guerard sells futures at 93 and the discount yield rises to 10%, meaning more
interest payments on Guerard=s variable debt, being able to buy back the
futures at 90 and realize the 3-point gain will offset the higher interest
payments.
11-53
P11.11 (cont=d.)
Of course, futures are double-edged swords and require performance whether
conditions are favorable or not. Thus if interest rates go down, and interest
payments on the debt fall, those opportunity gains are wiped out by the losses
incurred to cover the short futures position when repurchasing at a higher cost.
Of the three alternativesCswap, options (interest rate cap) and futuresConly
the options retain the opportunity for gain, but at a known fixed cost. If
Guerard seeks to minimize risk then it must consider the terms and cost of
available caps offered by counterparties in the light of its own assessment of
future interest rate movements.
P11.12
INTEREST RATE SWAP: ENTRIES AND MARK TO
MARKET
Requirement 1:
The rise in LIBOR to 8.3% means that Johnson's variable interest rate is 9.5%
(8.3% + 120bp). As part of its normal bookkeeping process, Johnson accrues
$237,500 [= (.095 X $10,000,000)/4] of interest expense on its floating rate
debt. Under the swap, Johnson receives the $237,500 floating interest from the
intermediary while paying $225,000 [= (.09 X 10,000,000)/4] fixed to the
intermediary. The entry to record the $12,500 (= $237,500 - $225,000) net
payment from intermediary follows.
Cash
12,500
Interest Expense
To record net payment from intermediary under the swap,
adjusting interest expense to $225,000.
12,500
Note to Instructor: Students may also have shown Johnson's entry to record
the $237,500 of interest expense.
11-54
P11.12 (cont=d.)
Requirement 2:
With LIBOR rising by .5%, the fixed rate is assumed to also rise by .5% to
.095 or .02375/quarter.
We now discount the fixed side of the swap as follows:
Interest:
$1,244,525 =
=
Principal:
8,686,334 =
$9,930,859
225,000/1.02375 + 225,000/(1.02375)2 +
225,000/(1.02375)3 + 225,000/(1.02375)4
+ 225,000/(1.02375)5 + 225,000/(1.02375)6
219,780 + 214,682 + 209,701 + 204,836
+ 200,084 + 195,442
10,000,000/(1.02375)6
Thus, the fixed side of the swap (liability) decreases in fair value by $69,141
(= $10,000,000 - $9,930,859). Equivalently, $69,141 equals the present value
of the six-period ordinary annuity of $12,500 (= $237,500 - $225,000)
discounted at 2.375% per period. This unrealized gain is recorded as follows:
Investment in Swaps
69,141
Gain on Hedge Activity
To mark the swap to market, recognizing that it has gone
"in the money" by providing net payments from intermediary.
NOTE: There would also be an offsetting entry to mark the hedged
investments to market.
11-55
69,141
P11.12 (cont=d.)
Requirement 3:
Assuming that the $65,000 value change created by the .5% rise in interest
rates relates to both the swap and the fixed rate investments, the carrying value
of both is adjusted by that amount.
Investment in Swaps
65,000
Gain on Hedge Activity
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
65,000
Investments (Fixed-Rate)
To mark the fixed rate investments to market, indicating
the decrease in present value of the investments' fixed receipts.
65,000
Requirement 4:
Investment in Swaps
65,000
Other Comprehensive Income
To mark the swap to market, reporting the value change
of this cash flow hedge in other comprehensive income.
11-56
65,000
P11.13
CRITIQUE PROPOSED CURRENCY/INTEREST RATE
SWAP ARRANGEMENT
Requirement 1:
About the best that can be said is that the proposed swap is backwards, for the
following reasons.
1.
Reno is borrowing ,10,000,000 but it needs dollars now and pounds in
three years when the ,10,000,000 is due.
2.
SB is borrowing $16,000,000 but it needs pounds now and dollars in
three years when the $16,000,000 is due.
3.
On each intervening June 24, Reno needs pounds, not dollars, to pay the
, interest on the ,10,000,000 loan.
The parties must have intended the following, the opposite of the arrangements
described in the problem.
4.
On 6/24/X6, Reno is to swap the ,10,000,000 loan proceeds to SB for
$16,000,000 to be used in the U.S. SB swaps its $16,000,000 loan
proceeds for ,10,000,000 to be used in the U.K.
5.
On 6/24/X9, Reno is to swap $16,000,000 to SB for ,10,000,000 to
repay the pound-denominated loan. And SB gets the $16,000,000 it
needs to repay the dollar-denominated loan.
6.
Regarding the interest due on the three June 24 dates, SB should pay
Reno enough pounds to cover Reno's floating pound interest in
exchange for $1,440,000 for SB's fixed dollar interest.
11-57
P11.13 (cont=d.)
Requirement 2:
For the year ended June 24, 20X9:
Foreign
Currency
Needed by
Reno
Swaps (items 4-6 above) ,11,080,000 (1)
No swaps
11,080,000 (1)
Dollars saved w/o swaps
Dollars Paid
Exchange
By Reno
Rate
$17,440,000 (2) 1.574/, (4)
16,620,000 (3)
1.500/,
$ 820,000
(1) ,11,080,000 = ,10,000,000 principal + ,1,080,000 (= .108 X
,10,000,000) interest.
(2) $17,440,000 = $16,000,000 principal + $1,440,000 interest.
(3) $16,620,000 = $1.5 X ,11,080,000.
(4) $1.574/, = $17,440,000/,11,080,000
Thus without the swaps in 20X9, Reno could have acquired the ,11,080,000
needed for $16,620,000 because the dollar strengthened and the exchange rate
dropped to $1.50/,, and would have realized a savings of $820,000.
P11.14
COMPREHENSIVE DERIVATIVES AND SFAS 133
Requirement 1:
Most students will cite: Financial statement recognition of derivatives, fair
value as the valuation basis, and the availability of hedge accounting
provisions. Other important provisions include: consistent accounting for all
derivatives, creative approach to hedging, including recognizing firm
commitments and using other comprehensive income, and emphasis on
measuring hedge effectiveness.
11-58
P11.14 (cont=d.)
Requirement 2:
Students that look carefully at how the various derivatives operate, including
institutional arrangements, should identify futures contracts as the derivatives
least likely to be incrementally affected by SFAS 133's accounting rules.
Economic events relating to futures tend to be accompanied by cash
flowsCinitial margin requirement and daily cash settlement with the futures
exchange as value moves up and downCwhich, as realized transactions, are
accounted for naturally. SFAS 133 clearly affects the accounting treatment of
the value changes, but not their recognition. Prior practice, whatever its
specific accounting rules, did account for cash inflows and outflows.
Options probably rank next as cash is paid to purchase an option but value
changes are unrealized and not likely to be naturally recognized. Interest rate
swaps were (are?) not well understood and it is hard to imagine anything other
than periodic cash settlement payments between counterparties and
intermediaries being recognized.
NOTE TO INSTRUCTOR: Some students will observe that intermediaries and
other market-makers or traders in these derivatives would have recognized the
derivatives at fair value, including value changes, so that SFAS 133 likely has
much less of an effect on these entities than on the end-users.
Requirement 3:
When used for speculation, SFAS 133 requires full recognition of derivatives=
value changes in earnings. In Anormal markets@ one expects modest price
changes, both up and down; even interest rates should not fluctuate greatly.
We believe, however, that the three derivative types affect earnings in the
following order: interest rate swaps (greatest), futures contracts, and options
(least). Our reasons are: (1) any change in interest rates affects the present
value of the entire stream of payments remaining in the swap and should
produce the greatest earnings effects; (2) options that are out of the money are
11-59
P11.14 (cont=d.)
likely to have minimal value changes and, because of their one-sided nature,
periodic earnings effects should be less than (3) futures contracts which have
two sides to be affected but do not likely involve streams of future payments to
be affected as do interest rate swaps.
NOTE TO INSTRUCTOR: The above answer to this speculative problem is
itself speculative since no numbers are given. Counterexamples to that answer
certainly exist so there probably is no right or wrong ranking. Of greater
importance is the quality of the student=s explanation.
Requirement 4:
Forwards are advantageous when the arrangement must be tailor-made or the
item needed is not traded on a futures market, delivery from/to the
counterparty is actually contemplated, deferred cash settlement is desired, and
minimal risk of nonperformance exists.
Futures are advantageous when standardized amounts of items traded are
sufficient, delivery is contemplated at a cash market and not through the
exchange, flexibility and liquid markets are important, immediate periodic cash
settlements are acceptable, and nonperformance risk of alternatives is high.
Organized futures markets are likely to be more efficient than informal
forward markets and, if they can be used, will probably produce the same
hedging benefits as forwards at lower cost.
Options are advantageous when retaining the opportunity for gain is important
and the cost palatable, and deferred cash settlement is desired. Dealing with
options traded on organized exchanges is likely to be more efficient than
dealing with informal options traders.
11-60