Chapter 13

Basic Derivatives

PROBLEM 1: TRUE OR FALSE

1. FALSE
2. FALSE
3. TRUE
4. FALSE
5. TRUE
6. TRUE
7. TRUE
8. TRUE
9. TRUE
10. TRUE

PROBLEM 2: FOR CLASSROOM DISCUSSION

1. C
2. A
3. D
4. C
5. D
6. C
7. A
8. D
9. D
10. C
11. C

12. Solutions:

 Dec. 15, 20x1 (Contract date)

Hedged item – None Forward contract (Derivative)

Dec. 15, 20x1
No entry

 Dec. 31, 20x1 (Reporting date)

The value of the derivative is computed as follows:

 Purchase price under the forward contract (10,000 x 1.24) 12,400
Purchase price in the market (10,000 x 1.27) 12,700
Gain/ Derivative asset 300

Dec. 31, 20x1

Forward contract (asset).. 300
Gain on forward contract.. 300
[(1.27 forward rate – 1.24 forward rate) x
10K]

 Jan. 15, 20x2 (Settlement date)

Gross settlement

Jan. 15, 20x2

Cash - foreign currency.. .13,000
(10K x 1.30)
Cash - local currency….….12,400
Forward contract (asset)… 300
Gain on forward contract.... 300
[(1.30 – 1.27) x 10K]

Net cash settlement

Hedged item – None Forward contract (Derivative)

Jan. 15, 20x2 Jan. 15, 20x2
Cash [(1.30 – 1.24) x 10K]….. 600
Forward contract (asset)… 300
Gain on forward contract.... 300
[(1.30 – 1.27) x 10K]

13. Solution:

Hedged item – None Futures contract (Derivative)

Dec. 1, 20x1
Deposit with broker ……..10K
Cash………………………..10K

to record the initial margin deposit with

the broker
 Hedged item – None Futures contract (Derivative)
Dec. 31, 20x1
Futures contract (asset)...20K
Gain on futures contract…..20K
[(100 - 98) x 10,000]

to record the value of the derivative

computed as the change in the underlying
multiplied by the notional amount.

Hedged item – None Futures contract (Derivative)

Jan. 31, 20x2
Cash ……………………… 40K
Deposit with broker…….....10K
Futures contract (asset)…. 20K
Gain on futures contract….10K
[(98 - 97) x 10,000]

to record the net cash settlement of the

futures contract.

14. Solution:

Hedged item – None Call option (Derivative)

Mar. 1, 20x1
Call option ……..…….. 400
Cash………..……………… 400

Hedged item – None Call option (Derivative)

June 30, 20x1
Call option ……..…….. 20,000
[(120 – 100) x 1,000]
Gain on call option………. 20,000

to record the increase in the fair value of

the call option due to the increase in
intrinsic value.

June 30, 20x1

Loss on call option……….300
(400 – 100)
Call option……………………..300

to record the decrease in the fair value of

the call option due to the decrease in
time value.
 Hedged item – None Call option (Derivative)
July 1, 20x1
Cash…………………20,000
[(120 – 100) x 1,000]
Loss on call option…....100
Call option ……..……..…..20,100
(400 + 20,000 – 300)

to record the net settlement of the call

option contract.

15. Solution:

 Jan. 1, 20x1

Hedged item – None Interest rate swap (Derivative)

Jan. 1, 20x1
No entry

 Dec. 31, 20x1

The net cash settlement on the swap is determined as follows:

  20x1 20x2
Receive variable a 120,000 150,000
Pay 12% fixed 120,000 120,000
Net cash settlement - receipt - 30,000
a
The interest rates used are the current rates as at the beginning of
the year (i.e., 1M x 12% = 120,000) & (1M x 15% = 150,000).

The net cash settlement in 20x2 is discounted to determine the fair

value of the derivative on Dec. 31, 20x1:

30,000 x PV of 1 @ 15%, n=1 = 26,087 (asset)

Hedged item – None Interest rate swap (Derivative)

Dec. 31, 20x1
Interest rate swap…..26,087
Gain on int. rate swap…..26,087

to recognize the change in the fair value

of the interest rate swap
 Dec. 31, 20x2

Hedged item – None Interest rate swap (Derivative)

Dec. 31, 20x2
Cash…………………30,000
Interest rate swap……....26,087
Gain on int. rate swap…...3,913
to record the net cash settlement of the
interest rate swap
PROBLEM 3: EXERCISES
1. Solutions:

 Dec. 1, 20x1 (Contract date)

Hedged item – None Forward contract (Derivative)

Dec. 1, 20x1
No entry

 Dec. 31, 20x1 (Reporting date)

The value of the derivative is computed as follows:

Purchase price under the fwd. contract (1,000 x 250) 250,000

Purchase price in the market (1,000 x 285) 285,000
Gain/ Derivative asset 35,000

The entry on December 31, 20x1 is as follows:

Hedged item – None
Forward contract (Derivative)
Dec. 31, 20x1
Forward contract (asset)…..35K
Gain on forward contract....35K
[ (285 - 250) x 1,000]

to record the value of the derivative

 Jan. 15, 20x2 (Settlement date)

Gross settlement

Hedged item – None Forward contract (Derivative)

Jan. 15, 20x2
Inventory (coffee beans)..245K
Loss on forward contract…40K
Cash…………………. …...250K
(1,000 x 250 agreed price)
Forward contract (asset)......35K

to record the purchase of 1,000 kilograms

of coffee beans at the pre-agreed sale
price of ₱250 per kilogram
Net cash settlement

Hedged item – None Forward contract (Derivative)

Jan. 15, 20x2

Loss on forward contract…..40K

Cash [(250 – 245) x 1,000]…….5K
Forward contract (asset)......35K

to record the net cash settlement of the

forward contract

2. Solutions:

 Dec. 15, 20x1 (Contract date)

Hedged item – None Forward contract (Derivative)

Dec. 15, 20x1
No entry

 Dec. 31, 20x1 (Reporting date)

Hedged item – None Forward contract (Derivative)

Dec. 31, 20x1
Loss on forward contract....2,500
Forward contract (liability)…..2,500
[ (1.25 – 1.50) x 10,000]

to record the value of the derivative

 Jan. 15, 20x2 (Settlement date)

Gross settlement

Jan. 15, 20x2

Cash - foreign currency.. . 16,000
(10K x 1.60)
Forward contract (liability). 2,500
Cash - local currency….….15,000
(10K x 1.50)
Gain on forward contract....3,500
[(1.60 – 1.25) x 10K]
Net cash settlement

Hedged item – None Forward contract (Derivative)

Jan. 15, 20x2 Jan. 15, 20x2
Cash [(1.60 – 1.50) x 10K]….. 1,000
Forward contract (liability). 2,500
Gain on forward contract.... 3,500

3. Solution:

Hedged item – None Futures contract (Derivative)

Dec. 1, 20x1
Deposit with broker ……..10K
Cash………………………..10K

to record the initial margin deposit with

the broker

Hedged item – None Futures contract (Derivative)

Dec. 31, 20x1
Futures contract (asset)...200K
Gain on futures contract…..200K
[(100 - 98) x 100,000]

to record the value of the derivative

computed as the change in the underlying
multiplied by the notional amount.

Hedged item – None Futures contract (Derivative)

Jan. 31, 20x2
Loss on futures contract….500K
[(98 – 103) x 100K]
Deposit with broker……..... 10K
Futures contract (asset)…. 200K
Cash ……………………… 290K

to record the net cash settlement of the

futures contract.

4. Solution:

Hedged item – None Put option (Derivative)

Mar. 1, 20x1
Put option ……..…….. 720
Cash………..……………… 720
 Hedged item – None Put option (Derivative)
June 30, 20x1
Put option ……..…….. 60,000
[(180 – 120) x 1,000]
Gain on put option………. 60,000

to record the increase in the fair value of

the put option due to the increase in
intrinsic value.

June 30, 20x1

Loss on put option……….540
(720 – 180)
Put option……………………..540

to record the decrease in the fair value of

the put option due to the decrease in time
value.

Hedged item – None Put option (Derivative)

July 1, 20x1
Cash…………………60,000
[(180 – 120) x 1,000]
Loss on call option….... 180
Call option ……..……..…..60,180
(720 + 60,000 – 540)

to record the net settlement of the call

option contract.

5. Solution:
Hedged item – None Put option (Derivative)
July 7, 20x4 July 7, 20x4
Put option ……..…….. 170
Cash………..……………… 170

Hedged item – None Put option (Derivative)

Sept. 30, 20x4 Sept. 30, 20x4
No entry 1

Sept. 30, 20x4

Loss on put option……….82
(170 – 88)
Put option……………………..82

to record the decrease in the fair value of

the put option due to the decrease in time
value.
1
The option is out of the money (i.e., the entity is better off selling in the
market at the market price of $54 rather than exercising the put option and
sell at $50).

The entity need not recognize a loss from the change in intrinsic value
because the option is not designated as a hedging instrument. Only the
change in the time value is accounted for. The maximum loss that would be
recognized in an option is the premium paid (i.e., $170) which is equal to the
time value of the option on initial recognition.

Hedged item – None Put option (Derivative)

Dec. 31, 20x4 Dec. 31, 20x4
No entry (see explanation above)

Dec. 31, 20x4

Loss on put option……….53
(88 - 35)
Put option……………………..53

to record the decrease in the fair value of

the put option due to the decrease in time
value.

Hedged item – None Put option (Derivative)

Jan. 31, 20x5 Jan. 31, 20x5
No entry (see explanation above)

Jan. 31, 20x5

Loss on put option……….35
(35 - 0)
Put option……………………..35

to record the decrease in the fair value of

the put option due to the decrease in time
value.

The movements in the put option account are analyzed as follows:

Put option
7/7/x
170
4
82 9/30/x4
53 12/31/x4
35 1/31/x5
-
6. Solution:

Hedged item – None Interest rate swap (Derivative)

Jan. 1, 20x2 Jan. 1, 20x2
No entry

The net cash settlement on the swap is determined as follows:

  20x2
Receive variable (1M x 8%) 80,000
Pay 9% fixed 90,000
Net cash settlement –
10,000
payment
Net cash settlements – payment
10,000
(each due on Dec. 31, 20x2 and Dec. 31, 20x3)
PV of ordinary annuity of 1 @ 8%, n=2 1.78326
Fair value of derivative - 12/31/x1 (asset) 17,833

Dec. 31, 20x1 Dec. 31, 20x1

Loss on int. rate swap….17,883
Interest rate swap….. 17,883

to recognize the change in the fair value

of the interest rate swap

Dec. 31, 20x2 Dec. 31, 20x2

Interest rate swap…..10,000
Cash………. 10,000

to record the periodic net cash settlement

on the interest rate swap - (see previous
computation)

The net cash settlement in 20x3 is determined as follows:

  20x3
Receive variable (1M x 12%) 120,000
Pay 9% fixed 90,000
Net cash settlement – receipt 30,000

Net cash receipt (due on Dec. 31, 20x3 – maturity date) 30,000
Multiply by: PV of 1 @12%, n=1 0.892857
Fair value of derivative - 12/31/x2 (asset) 26,786

The change in the fair value of the interest rate swap is determined as
follows:

Fair value of interest rate swap – Dec. 31, 20x2 - (asset) 26,786
Less: Carrying amount of interest rate swap – Dec. 31,
20x2
(17,833 liability – 10,000 net cash settlement) - (liability) 7,833
34,61
Change in fair value – gain
9

Hedged item – None Interest rate swap (Derivative)

Dec. 31, 20x2
Interest rate swap……34,619
Gain on int. rate swap…34,619

to recognize the change in the fair value

of the interest rate swap

Hedged item – None Interest rate swap (Derivative)

Dec. 31, 20x3
Cash…………………30,000
Interest rate swap………26,786
Gain on int. rate swap…...3,214

to record the final net cash settlement

on the interest rate swap

7. Solutions:

Requirement (a):
Receive fixed (12% x 3,000,000) = 360,000
Pay variable (9% x 3,000,000) = 270,000
Net receipt = 90,000
90,000 x PV of 1 @9%, n=1 = 82,569 asset

Requirement (b):
Cash 90,000
Interest rate swap 82,569
Gain 7,431
PROBLEM 4: CLASSROOM ACTIVITIES

1. Solutions:

 Dec. 15, 20x1 (Contract date)

Hedged item – None Forward contract (Derivative)

Dec. 15, 20x1
No entry

 Dec. 31, 20x1 (Reporting date)

Dec. 31, 20x1

Loss on forward contract.. 100K
Forward contract (liability).. 100K
[(51 - 50) x 100K]

 Jan. 15, 20x2 (Settlement date)

Gross settlement

Jan. 15, 20x2

Cash - local currency.. . 5M
(100K x 50)
Fwd. contract (liability)..100K
Cash - foreign currency….….4.7M
Gain on forward contract.... 400K

Net cash settlement

Hedged item – None Forward contract (Derivative)

Jan. 15, 20x2 Jan. 15, 20x2
Cash [(50 –47) x 100K]….. 300K
Fwd. contract (liability)…..100K
Gain on forward contract.... 400K
2. Solution:

Hedged item – None Futures contract (Derivative)

Dec. 1, 20x1
Deposit with broker ……..40K
Cash………………………..40K

to record the initial margin deposit with

the broker

Hedged item – None Futures contract (Derivative)

Dec. 31, 20x1
Futures contract (asset)...200K
Gain on futures contract…..200K
[(300 - 298) x 100,000]

to record the value of the derivative

computed as the change in the underlying
multiplied by the notional amount.

Hedged item – None Futures contract (Derivative)

Jan. 31, 20x2
Cash ……………………… 340K
Deposit with broker……..... 40K
Futures contract (asset)…. 200K
Gain on futures contract….100K
[(298 - 297) x 100,000]

to record the net cash settlement of the

futures contract.
3. Solution:

Hedged item – None Call option (Derivative)

Apr. 1, 20x1
Call option ……..…….. 20K
Cash………..……………… 20K

Hedged item – None Call option (Derivative)

June 30, 20x1
Call option ……..…….. 1M
[(600 – 500) x 10,000]
Gain on call option………. 1M

to record the increase in the fair value of

the call option due to the increase in
intrinsic value.

June 30, 20x1

Loss on call option……….15K
(20K – 5K)
Call option……………………..15K

to record the decrease in the fair value of

the call option due to the decrease in
time value.

Hedged item – None Call option (Derivative)

July 1, 20x1
Cash……………………1M
[(600 – 500) x 10,000]
Loss on call option….... 5K
Call option ……..……..….1.005M
(20K + 1M – 15K)

to record the net settlement of the call

option contract.

4.Solution:
 Jan. 1, 20x1

Hedged item – None Interest rate swap (Derivative)

Jan. 1, 20x1
No entry
 Dec. 31, 20x1

The net cash settlement on the swap is determined as follows:

  20x1 20x2
Receive variable 140,000 120,000
Pay 14% fixed 140,000 140,000
Net cash settlement -
- 20,000
payment

Net cash settlement – payment (due on Dec. 31, 20,000

20x2)
0.89285
PV of 1 @ 12%, n=1
7
Fair value of derivative - 12/31/x1 (liability) 17,857

The entry on December 31, 20x1 is as follows:

Hedged item – None Interest rate swap (Derivative)
Dec. 31, 20x1
Loss on int. rate swap…..17,857
Interest rate swap……..17,857

to recognize the change in the fair value

of the interest rate swap

 Dec. 31, 20x2

The entry on December 31, 20x2 is as follows:

Hedged item – None
Interest rate swap (Derivative)
Dec. 31, 20x2
Interest rate swap……..17,857
Loss on int. rate swap….2,143
Cash…………………20,000

to record the net cash settlement of the

interest rate swap

5.Solution:
 Jan. 1, 20x1

Hedged item – None Interest rate swap (Derivative)

Jan. 1, 20x1
No entry
 Dec. 31, 20x1

The net cash settlement on the swap is determined as follows:

  20x1 20x2
Receive variable (1M x 6%) & (1M x 60,000 70,000
7%)
Pay 6% fixed 60,000 60,000
Net cash settlement – receipt - 10,000

Net cash receipt (due annually starting on Dec. 31, 20x2) 10,000
PV of ordinary annuity of 1 @7%, n=2 1.808018
Fair value of derivative - 12/31/x1 (asset) 18,080

The entry on December 31, 20x1 is as follows:

Hedged item – None Interest rate swap (Derivative)

Dec. 31, 20x1
Interest rate swap……...18,080
Gain on int. rate swap...18,080

to recognize the change in the fair value

of the interest rate swap

 Dec. 31, 20x2

Hedged item – None Hedging instrument –

Interest rate swap (Derivative)
Dec. 31, 20x2
Cash…………………….10,000
Interest rate swap……...10,000

to record the periodic net cash settlement

on the interest rate swap - (see previous
computation)

  20x3
Receive variable (1M x 4%) 40,000
Pay 6% fixed 60,000
Net cash settlement –
20,000
payment
Net cash payment (due on Dec. 31, 20x3 – maturity date) 20,000
Multiply by: PV of 1 @%,4 n=1 0.961538
Fair value of derivative - 12/31/x2 (liability) 19,231

The change in the fair value of the interest rate swap is determined as
follows:

Fair value of interest rate swap – Dec. 31, 20x2 - (liability) 19,231
Less: Carrying amount of interest rate swap – Dec. 31,
20x2
(18,080 asset – 10,000 net cash settlement) - (asset) 8,080
27,31
Change in fair value – loss
1

The entry to adjust the carrying amount of the derivative is as follows:

Hedged item – None Interest rate swap (Derivative)

Dec. 31, 20x2
Loss on int. rate swap.…27,311
Interest rate swap………27,311

to recognize the change in the fair value

of the interest rate swap

 Dec. 31, 20x3

The entry on December 31, 20x3 is as follows:

Hedged item – None
Interest rate swap (Derivative)
Dec. 31, 20x3
Interest rate swap………19,231
Loss on int. rate swap… 769
Cash………………… 20,000

to record the final net cash settlement

on the interest rate swap
PROBLEM 5: MULTIPLE CHOICE - THEORY
1. B – underlying, not notional amount
2. A
3. B
4. B
5. D
6. D
7. C
8. B
9. B
10. C

PROBLEM 6: MULTIPLE CHOICE – COMPUTATIONAL

1. B (1.20 – 1.25) x 1,000,000 = 50,000 loss

2. C (1.27 – 1.25) x 1,000,000 = 20,000 gain

3. B (1.20 – 1.27) x 1,000,000 = 70,000 loss

4. B (300 – 245) x 1,000 = 55,000 receipt

5. C (300,000 – 290,000) x 10 = 100,000 derivative asset

6. C (200,000 liability ÷ 100,000 euros) = 2 increase in rate; 60 + 2 = 62

7. D
Cash [1M x (0.47 – 0.45)]..………… 20,000
Forward contract (liability) squeeze. 25,000
Gain on forward contract…………………………45,000

8. C (1.2M – 1M) = 200,000

9. B
Initial recognition
Call option 15,000
Cash 15,000

Reporting date
Loss on call option 10,000
(499 – 500) x 10,000
Call option 10,000

Expiration date
Loss on call option 5,000*
Call option 5,000

*The balance of the option premium: 15,000 – 10,000 loss on reporting date.
10. C [(100 – 97) x 10,000 units] + 20,000 initial margin deposit = 50,000
receipt

11. B (12% - 10%) x 500,000 x PV of 1 @ 12%, n=1 = 8,929

12. B
Solution:

Payment without the call option (¥80M ÷ ¥93) 860,215.05

Payment by exercising the call option (¥80M ÷ ¥100) 800,000.00

Savings 60,215.05

Less: Cost of call option (12,000.00)

Net savings 48,215.05

13. D
Solution:
Payment without the call option (¥80M ÷ ¥105)
761,904.76
Payment by exercising the call option (¥80M ÷ ¥100)
800,000.00
Loss from exercising the option
(38,095.24)

14. C
Solution:
“Cougar pays Aggie’s fixed interest” (10% x 500,000) = 50,000
“Aggie pays Cougar’s variable interest” (8% x 500,000) = 40,000

Net settlement = Cougar pays the difference of 10,000

OR

(10% pay fixed - 8% receive variable) x 500,000 = 10,000 payment

15. D
Solution:
“Cougar pays Aggie’s fixed interest” (10% x 500,000) = 50,000
“Aggie pays Cougar’s variable interest” (12% x 500,000) = 60,000

Net settlement = Cougar receives the difference of 10,000

OR
(12% receive variable - 10% pay fixed) x 500,000 = 10,000 receipt