On May 1, 2011, Mosby Company received an order to sell a machine to a customer

Question

On May 1, 2011, Mosby Company received an order to sell a machine to a customer in Canada at a price of 2,000,000 Mexican pesos. The machine was shipped and payment was received on March 1, 2012. On May 1, 2011, Mosby purchased a put option giving it the right to sell 2,000,000 pesos on March 1, 2012 at a price of $190,000. Mosby properly designates the option as a fair value hedge of the peso firm commitment. The option cost $3,000 and had a fair value of $3,200 on December 31, 2011. The following spot exchange rates apply:
May 1, 2011: spot rate $0.095.
December 31,2011:spot rate $0.094.
March 1,2012:spot rate $0.089.

Mosby's Incremental borrowing rate is 12 percent, and the present value factor for two months at a 12 percent annual rate is .9803

1. What was the impact on Mosby's 2011 net income as a result of this fair value hedge of a firm commitment?

2. What was the impact on Mosby's 2012 net income as a result of this fair value hedge of a firm commitment?

3. What was the overall result of having entered into this hedge of exposure to foreign exchange risk?

Explanation / Answer

1) $1760.60 Decrease

2) $188760.60 Increase

3) $9000 net gain on the option

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