Chapter 7, Problem 54E

a.

To determine

Describe the economic reasoning for buying the call options.

Explanation of Solution

A derivative instrument is a financial instrument or other contract with all three of the following features:

•    Has one or more underlying provisions and one or more notional amounts or payment provisions or both. These terms determine the settlement or settlement amount and, in some cases, whether a settlement is necessary or not.

•    It involves no initial net investment or a smaller initial net investment than would be required for other types of contracts that would be forced to respond to changes in market factors in a similar way.

•    Its terms allow or warrant net settlement, it can simply be net settled through means outside the deal or it allows for the distribution of an item that places the receiver in a role not substantially different from net settlement.

All derivatives must always be calculated and published at fair value on each interim and annual financial reporting date in the balance sheet. The fair value of financial instruments is the most relevant measure and the only valid factor for derivative instruments.

Gains and losses on fair value hedges on different types of derivatives are expressed in the statement of income offsetting losses and gains on hedged trades.

If a derivative instrument qualifies as a fair value hedge, at each statement date, both the derivative and the asset or liability to which it relates shall be reported at fair value. In the derivative financial instrument, gains or losses on the hedged assets or liabilities are offset (in whole or in part) by losses or gains.

Gains and losses on cash flow hedges are stationed in accrued other systematic earnings until the sales arise and then allocated to the income statement to offset the losses and benefits in those transactions.

Hedging the exposure of a recognized asset or liability or a forecast transaction to cash flow variability that is attributable to a particular risk (referred to as a cash flow hedge).

Here, the buyer is a manufacturer that uses gold in products and if want to mitigate the risk of future price increases because he will not be able to increase the products' selling price readily. If gold prices rise, the profit on the purchased call options will roughly offset the higher price that pay for the gold to be used in the production process. And, if gold prices go down, then it will be going to lose the premium that is paid for the call options, but then he can buy gold at the lower price.

b.

To determine

Compute the options time value and intrinsic value at January and April.

Explanation of Solution

A derivative instrument is a financial instrument or other contract with all three of the following features:

•    Has one or more underlying provisions and one or more notional amounts or payment provisions or both. These terms determine the settlement or settlement amount and, in some cases, whether a settlement is necessary or not.

•    It involves no initial net investment or a smaller initial net investment than would be required for other types of contracts that would be forced to respond to changes in market factors in a similar way.

•    Its terms allow or warrant net settlement, it can simply be net settled through means outside the deal or it allows for the distribution of an item that places the receiver in a role not substantially different from net settlement.

All derivatives must always be calculated and published at fair value on each interim and annual financial reporting date in the balance sheet. The fair value of financial instruments is the most relevant measure and the only valid factor for derivative instruments.

Gains and losses on fair value hedges on different types of derivatives are expressed in the statement of income offsetting losses and gains on hedged trades.

If a derivative instrument qualifies as a fair value hedge, at each statement date, both the derivative and the asset or liability to which it relates shall be reported at fair value. In the derivative financial instrument, gains or losses on the hedged assets or liabilities are offset (in whole or in part) by losses or gains.

Gains and losses on cash flow hedges are stationed in accrued other systematic earnings until the sales arise and then allocated to the income statement to offset the losses and benefits in those transactions.

Hedging the exposure of a recognized asset or liability or a forecast transaction to cash flow variability that is attributable to a particular risk (referred to as a cash flow hedge).

An options contract is an agreement between a buyer and a seller which gives the option

buyer the right to buy or sell a particular asset at an agreed price at a later date. Options

contracts are often used in transactions involving securities, commodities, and real

estate.

The following is the option fair value analysis which is as follows:

Date	Time Value	Intrinsic Value	Total Fair Value Prior to Exercise
January	$1,500*	$0**	$1,500
April	$0	$5,000***	$5,000

Working notes:

The intrinsic value is calculated as the difference between the spot price and the price of the strike. The intrinsic value for April is ($291 spot − $ 291 strike) x 200 = $0.

2 April calls = 200 x $7.50 = $1,500

($316 − $291) x 200 = $5,000

c.

To determine

Mention the given hedge will be represented as a fair value edge or a cash flow edge.

Explanation of Solution

A derivative instrument is a financial instrument or other contract with all three of the following features:

•    Has one or more underlying provisions and one or more notional amounts or payment provisions or both. These terms determine the settlement or settlement amount and, in some cases, whether a settlement is necessary or not.

•    It involves no initial net investment or a smaller initial net investment than would be required for other types of contracts that would be forced to respond to changes in market factors in a similar way.

•    Its terms allow or warrant net settlement, it can simply be net settled through means outside the deal or it allows for the distribution of an item that places the receiver in a role not substantially different from net settlement.

All derivatives must always be calculated and published at fair value on each interim and annual financial reporting date in the balance sheet. The fair value of financial instruments is the most relevant measure and the only valid factor for derivative instruments.

Gains and losses on fair value hedges on different types of derivatives are expressed in the statement of income offsetting losses and gains on hedged trades.

If a derivative instrument qualifies as a fair value hedge, at each statement date, both the derivative and the asset or liability to which it relates shall be reported at fair value. In the derivative financial instrument, gains or losses on the hedged assets or liabilities are offset (in whole or in part) by losses or gains.

Gains and losses on cash flow hedges are stationed in accrued other systematic earnings until the sales arise and then allocated to the income statement to offset the losses and benefits in those transactions.

Hedging the exposure of a recognized asset or liability or a forecast transaction to cash flow variability that is attributable to a particular risk (referred to as a cash flow hedge).

The given transaction will be accounted as a cash flow hedge since it is a hedge of exposure relating to a forecast purchase of the inventory.

d.

To determine

Detail about the accounting treatment for the options’ time value and intrinsic values.

Explanation of Solution

A derivative instrument is a financial instrument or other contract with all three of the following features:

•    Has one or more underlying provisions and one or more notional amounts or payment provisions or both. These terms determine the settlement or settlement amount and, in some cases, whether a settlement is necessary or not.

•    It involves no initial net investment or a smaller initial net investment than would be required for other types of contracts that would be forced to respond to changes in market factors in a similar way.

•    Its terms allow or warrant net settlement, it can simply be net settled through means outside the deal or it allows for the distribution of an item that places the receiver in a role not substantially different from net settlement.

All derivatives must always be calculated and published at fair value on each interim and annual financial reporting date in the balance sheet. The fair value of financial instruments is the most relevant measure and the only valid factor for derivative instruments.

Gains and losses on fair value hedges on different types of derivatives are expressed in the statement of income offsetting losses and gains on hedged trades.

If a derivative instrument qualifies as a fair value hedge, at each statement date, both the derivative and the asset or liability to which it relates shall be reported at fair value. In the derivative financial instrument, gains or losses on the hedged assets or liabilities are offset (in whole or in part) by losses or gains.

An options contract is an agreement between a buyer and a seller which gives the option

buyer the right to buy or sell a particular asset at an agreed price at a later date. Options

contracts are often used in transactions involving securities, commodities, and real estate.

Changes in the time value of the options are reflected in current returns. Changes in the intrinsic value of the options are deferred in other comprehensive revenues.

e.

To determine

Specify the accounting treatment for unrealized gains or losses on the call option.

Explanation of Solution

A derivative instrument is a financial instrument or other contract with all three of the following features:

•    Has one or more underlying provisions and one or more notional amounts or payment provisions or both. These terms determine the settlement or settlement amount and, in some cases, whether a settlement is necessary or not.

•    It involves no initial net investment or a smaller initial net investment than would be required for other types of contracts that would be forced to respond to changes in market factors in a similar way.

•    Its terms allow or warrant net settlement, it can simply be net settled through means outside the deal or it allows for the distribution of an item that places the receiver in a role not substantially different from net settlement.

All derivatives must always be calculated and published at fair value on each interim and annual financial reporting date in the balance sheet. The fair value of financial instruments is the most relevant measure and the only valid factor for derivative instruments.

Gains and losses on fair value hedges on different types of derivatives are expressed in the statement of income offsetting losses and gains on hedged trades.

If a derivative instrument qualifies as a fair value hedge, at each statement date, both the derivative and the asset or liability to which it relates shall be reported at fair value. In the derivative financial instrument, gains or losses on the hedged assets or liabilities are offset (in whole or in part) by losses or gains.

An options contract is an agreement between a buyer and a seller which gives the option

buyer the right to buy or sell a particular asset at an agreed price at a later date. Options

contracts are often used in transactions involving securities, commodities, and real estate.

In accumulated other comprehensive income, unrealized gains or losses on the call option will be deferred and reclassified to earnings when the inventory is sold (i.e. when the earnings are impacted).