W10 Complex Instrument Excerise

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Apr 3, 2024

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Example 1 – Purchased call option We purchase a call option contract on January 2, 2020 from Baird Investment Corporation. The option gives us the right to purchase 1000 shares of Laredo Corporation at $100/share and it expires on April 30, 2020. We pay a premium of $400 for the right to buy the shares at this fixed price. At the time of the transaction Laredo’s shares are trading at $100. Why is this a derivative? What is the underlying? What is the value of this option on January 2, 2020? Solution: Why is this a derivative? 1. Its value responds to an underlying instrument’s value: the shares 2. The initial investment is low (the value of the underlying instrument involved is about $100,000, but the option is only $400) 3. It will settle at a future date What is the underlying? Shares of Laredo Corporation What is the value of this option on January 2, 2020? $400. Option Premium = Intrinsic value (market price – Strike Price) + Time Value Journal Entry for the company: Derivatives – Financial Assets/Liabilities 400 Cash 400 On March 31, 2020, the price of Laredo shares is $120/share. The option is trading at 20,100 The value of the option increased. The Journal entry is Derivatives – Financial Assets/Liabilities 19,700 Gain/Loss on Derivatives 19,700 (20,100-400) =19,700

On April 1, we settle the option is cash (net settlement) rather than taking delivery. The share price is still $120 on April 1. The difference between the market value and the value based on strike price is (120-100) *1000=20,000 Close the accounts related to the option to record the settlement Cash 20,000 Gain/Loss on derivatives 100 Derivatives – Financial assets/liabilities 20,100 Effect of call option on net income March 31, 2020 Increase in value of option $19,700 April 1, 2020 Settle call option (100) Total net income $19,600* April 1, 2020: Gross settlement of option Buy the shares Recognize the investment, close the derivatives balance FV-NI Investment 120,000 Gain/Loss on derivatives 100 Derivatives – Financial assets/liabilities 20,100 Cash 100,000

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Example 2: Forward Contract On February 1st, Prasad Inc. enters into a forward contract to purchase $2,000,000 USD at a rate of $1.29 CAD on April 30th. Today, the currency is trading at $1.28. The value of the forward contract today is $0. 1. Is this a derivative? 2. How is it different from the purchased option? 3. Accounting? Solution 1. Yes, three conditions are satisfied 2. No choice but commit to the actually purchase 3. Initially, no entry On April 30: (1) Net settlement (Cash settlement) Record the Cash Payment (net) Remove any carrying value of the forward contract (derecognize) Recognize gain/loss on derivatives in Net Income (2) Gross settlement (actual purchase happens) Record cash payment at locked in rate Removing the carrying value of the forward contract Record the usd purchased at spot rate Recognize gain/loss on derivatives in Net Income

Example 3: E16-9 1. On March 1, 2020, Loma Corporation issued $300,000 of 8% non-convertible bonds at 104, which are due on February 28, 2040. In addition, each $1,000 bond was issued with 25 detachable stock warrants, each of which entitled the bondholder to purchase one of Loma’s no par value common shares for $50. The bonds without the warrants would normally sell at $95. Loma prepares its financial statements in accordance with IFRS. Solution: The bond value is 95 or $285,000 Cash received 300,000*104 = 312,000 The difference is: 27,000 Cash 312,000 Bonds Payable 285,000 Contributed Surplus-Stock Warrants 27,000 2. Grand Corporation issued $10 million of par value, 9% convertible bonds at 97. If the bonds had not been convertible, the company’s investment banker estimates they would have been sold at 93. Grant Corp. had adopted ASPE, and would like to explore all options to report the convertible bond. Solution: The Bond value is: 9,300,000 The cash is: 9,700,000 Difference: 400,000 Two ways to record it Cash 9,700,000 Bonds Payable 9,700,000 Or Cash 9,700,000 Bonds Payable 9,300,000 Contributed Surplus – Conversion rights 400,000

3. Hussein Limited issued $20 million of par value, 7% bonds at 98. One detachable stock purchase warrant was issued with each $100 par value bond. At the time of the issuance, the warrants were selling at $6. Hussein Limited has adopted ASPE. Solution: Cash received: 19,600,000 Stock Warrants: 1,200,000 (=6*20,000,000/100) The value of bond: 18,400,000 Cash 19,600,000 Bonds Payable 18,400,000 Contributed Surplus – Stock Warrants 1,200,000 Or Cash 19,600,000 Bonds Payable 19,600,000 5. On December 1, 2020 Horton Company issued 500 of its $1,000, 9% bonds at 103. Attached to each bond was one detachable stock warrant entitling the holder to purchase 10 of Horton’s common shares. On December 1, 2020, the fair value of the bonds, without the stock warrants was 95. Horton Company prepares its financial statements in accordance with IFRS. Solution Cash received: 515,000 Bond Value: 475,000 Stock Warrants: 40,000 Cash 515,000 Bonds Payable 475,000 Contributed Surplus-Stock Warrant 40,000 The warrants are equity instruments since they are fixed for fixed.

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4. On July 1, 2020, Tien Limited called its 9% convertible bonds for conversion. The $10 million of par value bonds were converted into 1 million common shares. On July 1 st , there was $75,000 of unamortized discount applicable to the bonds and the company paid an additional $65,000 to the bondholders to induce conversion of all the bonds. At the time of the conversion, the balance in the account Contributed Surplus – Conversion Rights was $270,000 and the bonds fair value (ignoring the conversion feature) was $9,955,000. The company records conversion using the book value method. Solution: July 1, 2020 called convertible bonds for conversion: $75,000 unamortized discount $65,000 inducement paid Contributed Surplus – Conversion Right 270,000 Bond fair Value was 9,955,000 Book Value Method: IFRS Bonds Payable 9,925,000 Contributed Surplus – Conversion Right 270,000 Loss on Bond Conversion 65,000 Common Shares 10,195,000 Cash 65,000 ASPE Bonds Payable 9,925,000 Loss on Redemption of Bonds 30,000 Contributed Surplus – Conversion Right 270,000 Retained Earnings 35,000 Common Shares 10,195,000 Cash 65,000 Bond Fair value – Book Value is the loss: 9,955,000-9,925,000=30,000.

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Related Questions

Question 16?

1.) A put option for 1,000 XYZ Corporation shares has a total value of P12,250. Its extrinsic value is P300. If the underlying asset is currently valued at P400 per share, what is the exercise price of an XYZ share? a. P411.95 b. P288.15 c. P388.05 d. P311.85 e. None among the other choices

A28

You buy one, Jan 15, 2021 Alphabet Inc. (GOOG) put contract with strike price of $680 and pay a premium of $7. The put contract represents 100 shares of stock. What is the maximum net profit that you could gain from this strategy (be sure to include the cost of the option contract in your calculation)?

Today on August 18 Tesla Inc. stock (TSLA) trades at a spot price of $220 per share. A trader decides to buy a European call option contract (= 100 call options) on the stock with a strike price of $220 and maturity September 15 (i.e., in one month). The price of the European call option contract is $12 per option. (i) Under what circumstances does the trader make a gain on September 15? (ii) What is the maximum possible gain for the trader? (iii) What is the maximum possible loss for the trader? Provide short answers for (i). (ii), (iii).

You purchase AAPL put option with an exercise price of $120 for a premium of $4.5. You hold the option until the expiration date, when AAPL sells for $110 per share. Compute your profit per share and enter it without a dollar sign.

A put option on Iowa stock specifies an exercise price of $71. Today the stock’s price is $68. The premium on the put option is $8. Assume the option will not be exercised until maturity, if at all. Complete the following table for a speculator who purchases the put option (and currently does not own the stock)

Question 4?

1. WRE is currently trading at $120/share. You sold 8 PUT-option contracts on WRE with a strike price of $110 for $8 each. a. What will be your total $ and % gain/loss if WRE price is $130 at the expiration date? b. What will be your total $ and % gain/loss if WRE price is $115 at the expiration date? C. What will be your total $ and % gain/loss if WRE price is $100 at the expiration date?

Topic: Option Pricing When computing, please do not round off. Only final answers must be rounded off to two decimal places 1. ABC Corporation acquired a put option for 100 pieces of P50,000-face value bonds. The strike price is 105.75. If as of the valuation date, the market value of the bonds is 106.35, what is the position of the option? **For the answer, type in the following format: ex. IN300 for in the money by P300; OUT2000 for out the money by P2,000.

Suppose that you enter into a 6-month forward contract at a price of $100 on a non-dividend paying stock currently trading at $99. Assuming that the above forward price is the no-arbitrage price of the contract, which of the below is closest to the level of the annual interest rate (using discrete compounding)? Question 3Answer a. 4.1 % b. 1.0 % c. 3.1 % d. 2.0 %

Question 3?

Explain your answer

Question 9?

1. An investor takes the long position on a forward contract on a T-Bill that will expire in 125 days. The forward price at which he takes his position is 2.48% on a discount yield basis. If the underlying on this contract are T-Bills with a par value of $500,000, the amount that the investor would have to pay at contract expiration to take delivery of the T-Bills is closest to: A. $495,694 B. $495,753 C. $487,600 2. An investor borrows $2m from XYZ Bank at LIBOR-90 plus a quoted margin of 2%. If the LIBOR-90 effective for the 90-day loans equals 5%, the amount of interest that the investor will pay XYZ Bank is closest to: A. $140,000 B. $35,000 C. $65,000 3. An investor takes a long position on an FRA that is based on 90-day LIBOR and has 6 months till expiration. The FRA rate equals 5%. LIBOR-90 at various dates are given below: Today : 5% After 3 months: 5.5% After 6 months: 6% After 9 months: 6.5% After 1 year: 7% The payoff on the FRA to the investor assuming that the notional…

Emma purchased 10 call option contracts on Vergara stock with a strike price of $20 when the option was quoted at $0.78. The option expires today when the value of Vergara stock is $19.45. Ignoring trading costs and taxes, what is the net profit on this investment? A) $0 B) -780 C) 2000 D) -78 E) 78

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