# Accounting Chapter 9 Homework The Time Value Option Reflects Variety Factors

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Pages 9
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Authors Paul M. Fischer, Rita H. Cheng, William J. Tayler

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DM–1
DERIVATIVES MODULE
UNDERSTANDING THE ISSUES
1. The intrinsic value of a forward contract to
sell a commodity or currency is determined
by comparing the spot rate/price at the date
of inception of the forward to the spot
rate/price at a later valuation date. At date
of inception of the forward, the difference
between the forward rate and spot
the current spot price. The difference be-
tween these two values times the notional
amount represents the total intrinsic value.
The time value of an option is measured by
subtracting the intrinsic value from the total
value of the option.
2. A firm commitment to sell inventory is fixed
in terms of the quantity, price, and delivery
ment.
3. A cash flow hedge of a forecasted transac-
tion affects both current and future operat-
ue increases \$700, then the time value has
decreased by \$200. This \$200 change
would be recognized in current income.
Changes in the intrinsic value over time are
initially recorded as a component of other
comprehensive income and therefore do
not currently impact operating income.
4. Unlike a futures contract, an option contract
represents a right, rather than an obliga-
tion. While the option contract requires the
holder to make an initial nonrefundable
cash outlay, the holder can allow the option
to expire in unfavorable conditions. In the
case of a futures contract, the contract
6.5% fixed in exchange for receipt of a
variable rate of LIBOR plus 2%. If LIBOR is
greater than 4.5%, the borrower will gain
Derivatives Module—Exercises DM–2
EXERCISES
EXERCISE 1
Because the option hedges a forecasted transaction, the only impact on earnings prior to the
transaction actually taking place and then, in turn, affecting earnings itself will be changes in the
time value of the option.
The impact on earnings for the first and second 30-day period is a charge against earnings of
\$2,000 and \$2,500, respectively, to be recognized as an unrealized loss on the hedge.
30 Days Expiration
Beginning Later Date
Notional amount in tons ............................. 500 500 500
Strike price ................................................. \$1,200 \$1,200 \$1,200
First Next
30 Days 30 Days
Fixed interest (\$3 million × 8% × 1/12 year) ..................... \$20,000 \$20,000
Settlement of rate differences:
(8.1% vs. 8% on \$3 million × 1/12 year) ..................... 250
(7.8% vs. 8% on \$3 million × 1/12 year) ..................... (500)
Net interest expense ......................................................... \$20,250 \$19,500
DM–3 Derivatives Module—Exercises
EXERCISE 2
Corn Futures
June 1 June 30 July 31
Number of bushels ..................................... 150,000 150,000 150,000
Spot price/bushel ....................................... \$3.42 \$3.41 \$3.43
Future price/bushel .................................... \$3.56 \$3.53 \$3.54
Fair value of contract:
(original futures price vs. current
Time value (spot-forward difference)
Note A: Because the July 31 spot rate is greater than the June 30 spot rate, the contract has no in-
trinsic value. Therefore, the value of the contract must be traceable to time value.
As a result of the above hedging activity, the following changes would occur:
June
July
Increase (decrease) in value of inventory .... \$ (1,500) \$ 1,500
Gain (loss) on futures contract:
Exercise 2, Concluded
Wheat Futures
June 1 June 30 July 31
Number of bushels ..................................... 150,000 150,000 150,000
Spot price/bushel ....................................... \$6.20 \$6.19 \$6.175
Future price/bushel .................................... \$6.35 \$6.33 \$6.32
Fair value of contract:
(original futures price vs. current
As a result of the above hedging activity, the following changes would occur:
June
July
Increase (decrease) in value of inventory .... \$(1,500) \$(2,250)
Gain (loss) on futures contract:
EXERCISE 3
June 30
December 31
(1) Net interest expense:
(8.75% vs. 9% on \$4,000,000 × ½ year) .......... (5,000)
(2) Carrying value of note payable:
(3) Net unrealized gain (loss) on the swap ........................ \$ 0 \$ 0
EXERCISE 4
(1) Critical criteria that must be satisfied in order to justify classification as a fair value hedge
include the following:
a. At inception, the hedging relationship is identified and documented.
b. There is an expectation that the hedge will be highly effective. Effectiveness of the
hedge must be assessed at inception and on an ongoing basis.
(2) Several factors that could suggest that the hedge is highly effective include the following:
a. The option is for the same notional amount (100,000 bushels) as is the commitment.
(3) An option may provide more flexibility than a futures contract because an option does not
have to be exercised if it is out-of-the-money, unlike a future. Therefore, if corn prices in-
(4) The value of an option consists of two components: intrinsic value and time value. The for-
mer represents the extent to which the current spot price compares favorably to the strike
(5) Granted, with an option you are either in-the-money or you are not. Therefore, an option
(6) The initial time value component of an option’s value is allocated to earnings over the pe-
riod of the term of the option. The amount of time value allocated to each period is deter-
EXERCISE 5
30 Days 60 Days
Later
Later
Option A: Call Option
Investment in option (equal to fair value of option) ........ \$ 700 \$ 2,500
Other comprehensive income Dr (Cr):
Intrinsic value at inception out-of-the-money ........... \$ 0 \$ 0
Current intrinsic value out-of-the-money .................. 0
Current intrinsic value [200 × (\$1,510 – \$1,500)] ..... 2,000
Change in intrinsic value .................................... \$ 0 \$(2,000)
EXERCISE 6
(1) Analysis of changes in the value of the call option:
February 20 February 28 March 31 April 20
Notional amount in pounds ........ 300,000 300,000 300,000 300,000
Strike price ................................. \$1.60 \$1.60 \$1.60 \$1.60
28 Other Comprehensive Income.............................................. 3,000
Investment in Option ........................................................ 3,000
To record change in intrinsic value of option.
Investment in Option ............................................................ 400
Unrealized Gain on Option ............................................... 400
To record change in time value of option
(\$800 on February 20 vs. \$1,200 on February 28).
Mar. 31 Investment in Option ............................................................ 6,000
Other Comprehensive Income ......................................... 6,000
To record change in intrinsic value of option.
Apr. 20 Investment in Option ............................................................ 6,000
Other Comprehensive Income ......................................... 6,000
To record change in intrinsic value of option.
Unrealized Loss on Option ................................................... 300
Investment in Option ........................................................ 300
Exercise 6, Concluded
May 3 Inventory of Soybean Meal ................................................... 489,000
Cash ................................................................................. 489,000
To record purchase at \$1.63 per pound.
(2) The net effect on earnings with and without the cash flow hedge is as follows:
Without the With the
Hedge
Hedge
Assumed sales value ................................................................ \$ 300,000 \$ 300,000
EXERCISE 7
September December
June 30
30 31
Basis of 6% note payable:
(a) Balance per Schedule A .................................... \$6,089,100 \$4,089,543 \$2,059,993
Current quarter change in value of swap:
Interest expense:
Amount per Schedule A .......................................... \$ 120,887 \$ 91,337 \$ 61,343
Settlement of rate difference:
5.8% vs. 6% on \$10 million × ¼ year ................ (5,000)
5.6 % vs. 6% on \$10 million × ¼ year ............... (10,000)
Net interest expense ............................................... \$ 115,887 \$ 78,837 \$ 51,343
Schedule A: Amortization of Note Payable Without Swap
Quarter Payment Interest Principal Balance
\$ 10,000,000
Mar. 31 \$ 2,090,893 \$150,000 \$ 1,940,893 8,059,107
June 30 2,090,893 120,887 1,970,007 6,089,100
Schedule B: Quarterly Variable versus Fixed Rate Differences
Quarterly Interest at
Variable Variable Quarterly
Quarter Rate Fixed Rate Rate Fixed Rate Difference
June 30 5.80% 6.00% \$145,000 \$150,000 \$ (5,000)
Sept. 30 5.5 6.0 137,500 150,000 (12,500)
Exercise 7, Concluded
Summary of Entries Dr (Cr) over the Life of the Note Payable
Note Gain (Loss) Swap Gain (Loss)
Cash Payable Interest On Debt Asset on Swap
Beginning
Balance 10,000,000 (10,000,000)
Mar. 31 (2,090,893) 1,940,893 150,000
June 30 (2,090,893) 1,970,007 120,887
(14,954) 14,954 14,954 (14,954)
DM–11 Derivatives Module—Problems
PROBLEMS
PROBLEM M-1
(1) Value of Option March 29 March 31 April 30 May 18
Intrinsic value ......................... \$1,000 \$1,000 \$3,000 \$4,000
Time value .............................. 1,400 1,200 300 0
Total value .............................. \$2,400 \$2,200 \$3,300 \$4,000
Mar. 29 Investment in Put Option ............................................ 2,400
Cash ..................................................................... 2,400
To record purchase of option.
Apr. 30 Investment in Put Option ............................................ 1,100
Loss on Option (Time Value) ..................................... 900
Gain on Option (Intrinsic Value) ........................... 2,000
PROBLEM M-1, Concluded
May 18 Investment in Put Option ............................................ 700
Loss on Option (Time Value) ..................................... 300
Gain on Option (Intrinsic Value) ........................... 1,000
Inventory of Commodity A .......................................... 115,000
Firm Commitment ...................................................... 3,000
Cash ..................................................................... 118,000
To record purchase of inventory.
Cash ........................................................................... 4,000
Investment in Put Option ...................................... 4,000
June 16 Cash ........................................................................... 90,000
Sales Revenue ..................................................... 90,000
To record sale of one-half of the inventory.
Cost of Sales .............................................................. 70,000
(2) Desired Without the With the
Position Option Option

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