Exercise 1 (LO 3, 6) Hedging a foreign currency liability with an option designa
ID: 2727418 • Letter: E
Question
Exercise 1 (LO 3, 6) Hedging a foreign currency liability with an option designated as a fair value hedge.
Williams Corporation imports, from a number of German manufacturers, large machining equipment used in the tooling industry. On June 1, the company received delivery of a piece of machinery with a cost of 450,000 euros when the spot rate was 1 euro equals $1.370. Williams had already paid 50,000 euros, when the spot rate was 1 euro equals $1.350, to the German company at the time of placing the order, and the balance of the invoice was due in 60 days after delivery. On June 15, the company became concerned that the dollar would weaken relative to the euro and proceeded to purchase an option to buy euros on July 31 at a strike price of 1 euro equals $1.375. The hedge was designated as a fair value hedge. At the time of purchase, the out-of-the-money option had a value of $1,400 and a value of $2,600 at June 30. Euro spot rates are as follows
1 euro =
June 15
$1.373
June 30
1.381
July 31
1.385
On July 31, the option was settled and the foreign currency was remitted to the German vendor.
Assuming that financial statements are prepared for June and July, identify all relevant income statement and balance sheet accounts for the above transactions and determine the appropriate monthly balances.
1 euro =
June 15
$1.373
June 30
1.381
July 31
1.385
Explanation / Answer
Particulars
June 30
July 31
Inventory:
$67,500
$67,500
Down payment (50,000 euros x $1.350)
Due on balance(400,000 euros x $1.370)
$548,000
$548,000
Total
$615,000
$615,000
Accounts payable
(400,000 euros x $1.381)
(552,400)
Company investment in option
$2,600
2. Calculate income statement accounts:
Particulars
June 30
July 31
Loss of exchange:
(400,000 euros x ($1.381 - $1.370)
(400,000 euros x ($1.385 - $1.381)
$4,400
$1,600
Gain on option:
($2,600 - $1,400)
(spot price – strike price) 400,000 euros
($1.385 - $1.375) = $4,000
Less option value $2,600
($1,200)
($1,400)
Particulars
June 30
July 31
Inventory:
$67,500
$67,500
Down payment (50,000 euros x $1.350)
Due on balance(400,000 euros x $1.370)
$548,000
$548,000
Total
$615,000
$615,000
Accounts payable
(400,000 euros x $1.381)
(552,400)
Company investment in option
$2,600
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