Question

On June 1, a US firm contracts to sell equipment (with an asking price of 2,000,000 krona) in Sweden. The firm will take delivery and will pay for the equipment on August 1.

Spot rates were as follows (dollars per krona):

June 1 $0.107

August 1 $0.102

On August 1, the equipment was sold for 2,000,000 krona. The cost of the equipment was $100,000

Suppose that on June 1, the firm believes, based on recent changes in the economy that there is high probability of exchange rate losses from the transaction. If the firm acquires an option to hedge the transaction, answer the following questions

Required:

1. Does the firm believe that the krona is strengthening or weakening relative to the US dollar? (1 point)

2. What kind of option should the firm use: a put or a call option? (1 point)

3. Suppose the following options are available. Each option can only be exercised on August 1. Choose the option that should be used to hedge the transaction and record the journal entries needed by the company to record the hedge and the transaction to sell the equipment. Round all entries to the nearest whole dollar (10 points)

Option Type Amount Exercise Rate Cost to Acquire

Call Option 2,000,000 Krona $0.1035 $8,000

Put Option 2,000,000 Krona $0.1035 $15,000

4. Answer the following questions:

a. What is the accumulated net impact on the company’s Stockholder equity related to this transaction at August 1? (1 point)

b. What would have been the accumulated net impact on the company’s Stockholder equity related to this transaction at August 1 if the company had not entered the Option Contract? (1 point)

c. Was the company better- or worst off with the derivative contract? (1 point)

Answer 1

1. Company wants to sell the transaction and will get 2mn krona on 1 August. So it has 2mn krona receivable in future. Company will lose if krona falls in near future. So the Firm bellives that krona will fall in near future so it is wise to hedge this risk

2. Firm should use a put option on krona where it gains in case of fall of krona prices.

3. Firm should buy a put option at exercise price of $0.1035 by paying a preium of $15000

Journal enty on payment of Premium:

Debit Option Premium A/c $15000

Credit Bank A/c $15000   

On 1 Aug actual rate 0.102, so beenfit = ($0.1035-0.1020)= $0.0015

Benfit on execrising the option= 2000000 * 0.0015 = $3000

Releasation Amount :- 2000000*.01020=$204000

Debit Bank Account 204000

Credit Asset Account 100000

Credit Profit on sale of Assets 104000

4. a) Accumulated Net Impact on Company's Stockholder Equity from this transaction= ($204000-100000) - (15000-3000) = $92000

b) Accumulated Net Impact on company's Stockholder Equity if not entered into this option contract:- ($204000-100000)= 104000

c) company is worst off by entering into this derivative transaction