Chapter 7, Problem 51E

a.

To determine

Mention the relationship between sport and copper forward prices indicates the expectations of the market for copper prices through December.

Explanation of Solution

A derivative instrument is a financial instrument or other contract with all three of the following features:

•    Has one or more underlying provisions and one or more notional amounts or payment provisions or both. These terms determine the settlement or settlement amount and, in some cases, whether a settlement is necessary or not.

•    It involves no initial net investment or a smaller initial net investment than would be required for other types of contracts that would be forced to respond to changes in market factors in a similar way.

•    Its terms allow or warrant net settlement, it can simply be net settled through means outside the deal or it allows for the distribution of an item that places the receiver in a role not substantially different from net settlement.

All derivatives must always be calculated and published at fair value on each interim and annual financial reporting date in the balance sheet. The fair value of financial instruments is the most relevant measure and the only valid factor for derivative instruments.

Gains and losses on fair value hedges on different types of derivatives are expressed in the statement of income offsetting losses and gains on hedged trades.

If a derivative instrument qualifies as a fair value hedge, at each statement date, both the derivative and the asset or liability to which it relates shall be reported at fair value. In the derivative financial instrument, gains or losses on the hedged assets or liabilities are offset (in whole or in part) by losses or gains.

Gains and losses on cash flow hedges are stationed in accrued other systematic earnings until the sales arise and then allocated to the income statement to offset the losses and benefits in those transactions.

Hedging the exposure of a recognized asset or liability or a forecast transaction to cash flow variability that is attributable to a particular risk (referred to as a cash flow hedge).

A forward contract is a custom designed agreement between two parties to buy or sell an asset on a future date at a specified price. For hedging or speculation a forward contract may be used, although its non-standardized nature makes it particularly suitable for hedging.

As the forward price is lower than the spot price, the market is expected to fall in the price of the copper.

b.

To determine

Identify the risk which the purchase of the forward contract is intended to mitigate.

Explanation of Solution

A derivative instrument is a financial instrument or other contract with all three of the following features:

•    Has one or more underlying provisions and one or more notional amounts or payment provisions or both. These terms determine the settlement or settlement amount and, in some cases, whether a settlement is necessary or not.

•    It involves no initial net investment or a smaller initial net investment than would be required for other types of contracts that would be forced to respond to changes in market factors in a similar way.

•    Its terms allow or warrant net settlement, it can simply be net settled through means outside the deal or it allows for the distribution of an item that places the receiver in a role not substantially different from net settlement.

All derivatives must always be calculated and published at fair value on each interim and annual financial reporting date in the balance sheet. The fair value of financial instruments is the most relevant measure and the only valid factor for derivative instruments.

Gains and losses on fair value hedges on different types of derivatives are expressed in the statement of income offsetting losses and gains on hedged trades.

If a derivative instrument qualifies as a fair value hedge, at each statement date, both the derivative and the asset or liability to which it relates shall be reported at fair value. In the derivative financial instrument, gains or losses on the hedged assets or liabilities are offset (in whole or in part) by losses or gains.

Gains and losses on cash flow hedges are stationed in accrued other systematic earnings until the sales arise and then allocated to the income statement to offset the losses and benefits in those transactions.

Hedging the exposure of a recognized asset or liability or a forecast transaction to cash flow variability that is attributable to a particular risk (referred to as a cash flow hedge).

A forward contract is a custom designed agreement between two parties to buy or sell an asset on a future date at a specified price. For hedging or speculation a forward contract may be used, although its non-standardized nature makes it particularly suitable for hedging.

The firm commitment locks in the copper price, thereby protecting us from a price increase. If the price of copper falls, however, we forget the opportunity to buy it at the lower spot price. Buying a forward contract at $3.10 to sell copper allows the company to capture some of that profit and offset the fair value losses from the firm commitment.

c.

To determine

Mention the price at which the inventory will be acknowledged when it was purchased on

Dec 31 if the forecasts in the data have been accurate.

Explanation of Solution

A derivative instrument is a financial instrument or other contract with all three of the following features:

•    Has one or more underlying provisions and one or more notional amounts or payment provisions or both. These terms determine the settlement or settlement amount and, in some cases, whether a settlement is necessary or not.

•    It involves no initial net investment or a smaller initial net investment than would be required for other types of contracts that would be forced to respond to changes in market factors in a similar way.

•    Its terms allow or warrant net settlement, it can simply be net settled through means outside the deal or it allows for the distribution of an item that places the receiver in a role not substantially different from net settlement.

All derivatives must always be calculated and published at fair value on each interim and annual financial reporting date in the balance sheet. The fair value of financial instruments is the most relevant measure and the only valid factor for derivative instruments.

Gains and losses on fair value hedges on different types of derivatives are expressed in the statement of income offsetting losses and gains on hedged trades.

If a derivative instrument qualifies as a fair value hedge, at each statement date, both the derivative and the asset or liability to which it relates shall be reported at fair value. In the derivative financial instrument, gains or losses on the hedged assets or liabilities are offset (in whole or in part) by losses or gains.

Gains and losses on cash flow hedges are stationed in accrued other systematic earnings until the sales arise and then allocated to the income statement to offset the losses and benefits in those transactions.

Hedging the exposure of a recognized asset or liability or a forecast transaction to cash flow variability that is attributable to a particular risk (referred to as a cash flow hedge).

A forward contract is a custom designed agreement between two parties to buy or sell an asset on a future date at a specified price. For hedging or speculation a forward contract may be used, although its non-standardized nature makes it particularly suitable for hedging.

At the date of purchase, the inventory shall be recognized at its fair value. After settlement of the firm commitment and the derivative contract, the inventory will be recognized on the date of purchase at its fair value.

d.

To determine

Calculate the amount of the inventory's net cash costs if the forecasts in the given table

proves to be accurate.

Explanation of Solution

A derivative instrument is a financial instrument or other contract with all three of the following features:

•    Has one or more underlying provisions and one or more notional amounts or payment provisions or both. These terms determine the settlement or settlement amount and, in some cases, whether a settlement is necessary or not.

•    It involves no initial net investment or a smaller initial net investment than would be required for other types of contracts that would be forced to respond to changes in market factors in a similar way.

•    Its terms allow or warrant net settlement, it can simply be net settled through means outside the deal or it allows for the distribution of an item that places the receiver in a role not substantially different from net settlement.

All derivatives must always be calculated and published at fair value on each interim and annual financial reporting date in the balance sheet. The fair value of financial instruments is the most relevant measure and the only valid factor for derivative instruments.

Gains and losses on fair value hedges on different types of derivatives are expressed in the statement of income offsetting losses and gains on hedged trades.

If a derivative instrument qualifies as a fair value hedge, at each statement date, both the derivative and the asset or liability to which it relates shall be reported at fair value. In the derivative financial instrument, gains or losses on the hedged assets or liabilities are offset (in whole or in part) by losses or gains.

Gains and losses on cash flow hedges are stationed in accrued other systematic earnings until the sales arise and then allocated to the income statement to offset the losses and benefits in those transactions.

Hedging the exposure of a recognized asset or liability or a forecast transaction to cash flow variability that is attributable to a particular risk (referred to as a cash flow hedge).

A forward contract is a custom designed agreement between two parties to buy or sell an asset on a future date at a specified price. For hedging or speculation a forward contract may be used, although its non-standardized nature makes it particularly suitable for hedging.

For the inventory, the net purchase price is a spot rate of $2.75 times 100,000 lbs., or $275,000. The forward contract will be worth $35,000 (($3.10-$2.75) x 100,000) at the settlement date and the firm commitment specifies that the company is paying $310,000 ($3.10 x 100,000 lbs) for the purchase of copper. This hedge ensured that the company didn't overpay the copper at settlement; though, this arrangement would also have caused the company to forget any profits if copper's spot price increased above $3.10 / lb.