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CHAPTER 10
UNDERSTANDING THE ISSUES
1. If the U.S. dollar strengthens relative to a
FC, this means that the dollar commands
more FC. The direct exchange rate will
change in that 1 FC will be worth fewer
2. If the U.S. dollar is weakening against the
FC, then more dollars will be required to
settle FC purchases and exchange losses
will be experienced. These losses could be
hedged against through the use of a for-
ward contract to buy FC. Given a fixed for-
ward rate, the holder of the contract will
know exactly how many dollars it will take
to secure the necessary FC. As the value
of the payable to the foreign vendor in-
creases with resulting losses, the value of
3. A commitment to purchase inventory paya-
ble in FC is characterized by a fixed num-
ber of FC. However, the exchange rate for
the FC is subject to change; therefore, the
future transaction date. The losses on the
commitment could be offset by gains on the
hedging instruments. Furthermore, the firm
commitment account would then be used to
adjust the basis of the acquired inventory at
the date of the actual purchase transaction.
The basis adjustment would reduce the
cost of the inventory and allow for other-
wise increased profit margins.
4. The time value of an option is measured as
Ch. 10—Exercises 10–2
EXERCISES
EXERCISE 10-1
Balance sheet accounts—Debit (Credit): June 30 July 31
Inventory:
Down payment (50,000 euros × $1.350) .................. $ 67,500 $ 67,500
EXERCISE 10-2
(1) January 1 $0.125 = FC 1
Rate Spot Direct FC 8 = $1
Rate Spot Indirect
(2) U.S. Dollars Foreign Currency (FC)
Value today (assumed amount) ............. $100 800 FC
Interest rate ........................................... 4% 5%
10–3 Ch. 10—Exercises
Exercise 10-2, Concluded
(3) This suggests that the domestic (U.S.) interest rates are higher than those of the foreign
country. Assume that one wants to buy foreign currency in the future; therefore, they retain
(4) When the U.S. dollar is weak relative to a FC, it takes more U.S. dollars to equal the FC.
(5) If the dollar strengthened relative to the FC, the amount of FC would increase, and the for-
ward rate would decrease.
EXERCISE 10-3
(1) The intrinsic value of the option is represented by the difference between the strike price
and the spot rate times the notional amount. The time value is equal to the value of the op-
tion less the intrinsic value. For the subject option, these values are as follows:
February 1 April 30 May 31
Strike price ........................................ $ 2.05 $ 2.05 $ 2.05
Spot rate ............................................ $ 2.05 $ 2.08 $ 2.10
Notational amount ............................. 100,000 100,000 100,000
Exercise 10-3, Concluded
(2) Changes in the value of the forward contract are measured as the difference between the
value at the original forward rate versus the current forward rate. This difference in value is
then discounted back from the expiration date to the current date. For the subject forward
contract, the values are as follows:
February 1 April 30 May 31
Original forward value ............................ $207,000 $207,000
Current forward value ............................ $209,000 $210,000
(3) Given the hedge of an unrecognized commitment, changes in the value of the hedging
instrument would also be recognized as changes in the value of the commitment. When the
EXERCISE 10-4
(1) Apr. 15 No entry
May 1 Inventory ............................................................................... 343,500
$0.693.
June 30 Exchange Loss ..................................................................... 2,000
($0.687 – $0.691)]
Forward Contract .................................................................. 995
Gain on Forward Contract ................................................ 995
To record change in value of forward contract
when forward rate is 1 FC = $0.695. Change in
Aug. 1 Forward Contract .................................................................. 505
Gain on Forward Contract ................................................ 505
To record change in value of forward contract
when 1 FC = $0.696. Total change in forward
Foreign Currency .................................................................. 348,000
Cash ................................................................................. 346,500
Exercise 10-4, Concluded
(2) Stark, Inc.
Partial Income Statement
For the Year Ended June 30
Exchange gain (loss) ......................................................................................... $(2,000)
Stark, Inc.
Partial Balance Sheet
As of June 30
Inventory ............................... $343,500 Accounts payable ................. $345,500
EXERCISE 10-5
(1) Gain (loss) on commitment through September 15: FCA FCB
Number of FC in commitment:
$549,600 ÷ $1.200 ....................................... 458,000
Change in spot rate from commitment date to
transaction date:
$1.200 vs. $1.160 ......................................... $ 0.04
$0.685 vs. $0.692 ......................................... $ 0.007
Gain (loss) on commitment:
(2) Gross profit margin without the hedge:
Selling price at spot rate on date of sale:
458,000 x $1.16..................................................... $531,280
435,000 x $0.692................................................... $301,020
Cost of sales............................................................. 440,000 235,000
Gross profit without the hedge................................... $91,280 $66,020
10–7 Ch. 10—Exercises
(1) Hedge of a Hedge of a
Commitment Using Forecasted Transaction
Forward Forward
Contract Option Contract Option
Prior to transaction date:
Gain (loss) on commitment [100,000 FC × ($1.250 – $1.320)] ........ $ (7,000) $ (7,000)
Gain (loss) on hedging instrument:
Forward contract [100,000 FC × ($1.320 – $1.250)] .................. 7,000 —
Option [100,000 FC × ($1.320 spot – $1.250 strike)] ................. 7,000 —
(2) Based on the above analysis, it would appear that the decision to commit to the purchase or forecast the purchase would have
the same net effect on earnings if a forward contract were used. Furthermore, this would be the case even if the rates moved in
the opposite direction as that assumed. Therefore, if a forward contract were used, Jackson’s decision should focus on other
factors. The legal form of a commitment is certainly much different from that of a forecasted transaction. Jackson would have
much less flexibility with a commitment.
Exercise 10-6, Concluded
In conclusion, it would appear that the best alternative would be to forecast the transaction and hedge the forecast with an
option.
Note: If spot rates were to decline below the original rate of 1 FC = $1.250 and fall to 1 FC = $1.180, the alternatives would
appear as follows:
Hedge of a Hedge of a
Commitment Using
Forecasted Transaction
Forward Forward
Contract Option Contract Option
Prior to transaction date:
Gain (loss) on commitment [100,000 FC × ($1.250 – $1.180)] ........ $ 7,000
Gain (loss) on hedging instrument:
Forward contract [100,000 FC × ($1.180 – $1.250)] .................. (7,000)
Option (no intrinsic value – spot < strike) ...................................
Gain (loss) excluded from hedge effectiveness:
Forward contract [100,000 FC × ($1.270 – $1.250)] .................. (2,000) $ (2,000)
10–9 Ch. 10—Exercises
EXERCISE 10-7
Basis of Building Addition
Event or activity:
March 1 construction payment (200,000 FC × $1.50) ............................ $ 300,000
Capitalized interest on 2-month note:
200,000 FC × 4.8% × 2/12 year × $1.48 .......................................... 2,368
June 30 construction payment (300,000 FC × $1.55) ............................ 465,000
Capitalized interest on 6-month note:
300,000 FC × 6.0% × 3/12 year × $1.58 .......................................... 7,110
August 31 construction payment (400,000 FC × $1.60) ........................ 640,000
EXERCISE 10-8
Event A: Without the With the
Hedge
Hedge
Transaction exchange gain (loss)
[100,000 FC × ($1.100 – $1.150)] .............................................. $(5,000) $(5,000)
Forward contract gain (loss)
[100,000 FC × ($1.110 – $1.150)] .............................................. 4,000
Net income (loss) effect ................................................................... $(5,000) $(1,000)
Event B: Without the With the
Hedge
Hedge
Gain on commitment
[(200,000 FC × ($1.172 – $1.150)] discounted 1 month ............ $ 4,378
Sales (200,000 FC × $1.170) ........................................................... $ 234,000 234,000
PROBLEM 10-1
Transaction A:
Gain (Loss)
Exchange gain on exposed payable
[100,000 FC × ($1.140 – $1.150)] ............................... $ 1,000
Transaction B:
Gain (Loss)
Gain on commitment
[100,000 FC × ($1.150 – $1.132)] ............................... $ 1,800
Loss on forward contract
[100,000 FC × ($1.150 – $1.132)] ............................... (1,800)
$(3,067)
Transaction D:
Change in time value* ....................................................... $ (200)
* On November 30, the intrinsic value is $500 and the time value is $700, versus December 31,
PROBLEM 10-2
Balance sheet accounts—Debit (Credit): 2nd Quarter 3rd Quarter
Inventory of medical equipment ..................................... $ 325,000 $ —
Firm commitment ........................................................... (15,723)
Accounts receivable:
(800,000 FC × $0.470) ............................................. 376,000
Forward contract receivable............................................. 15,723 33,516
Note A:
June 1
June 30 August 15 September 30
Number of FC ......................................... 800,000 800,000 800,000 800,000
Spot rate—1 FC ...................................... $0.500 $0.485 $0.480 $0.470
Forward rate remaining time—1 FC = ..... $0.510 $0.490 $0.475 $0.468
Fair value of forward contract:
Present value of change:
n = 3.5, i = 0.50% ........................ $ 15,723
n = 0.5, i = 0.50% ........................ $ 33,516
Change in value from prior period:
