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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: MULTIPLE CHOICE – THEORY

1. B
2. D
3. C
4. A
5. B
6. B
7. C
8. B
9. D
10. D
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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
P250 per kilogram
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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]
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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.

* (103 – 100) x 100,000 = 300,000 less 10,000 deposit = 290,000 net cash payment
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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.
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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.
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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/x4 170
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

 Analysis:
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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 – payment (10,000)

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
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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
Change in fair value – gain 34,619

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

PROBLEM 4: MULTIPLE CHOICE – COMPUTATIONAL

1. B
Solution:
Fixed purchase price (₱600 x 1,000) 600,000
Purchase price at current market price (₱550 x 1,000) 550,000
Derivative liability - payable to broker (50,000)

2. A – (52 – 50) x 100,000 = 200,000 asset

3. D
Solution:
Loss on forward contract (squeeze) 300,000
Cash [(49 – 50) x 100,000] 100,000
Forward contract (see previous solution) 200,000

Alternative solution: (49 – 52) x 100,000 = 300,000 loss

4. A (40 – 65) x 20,000 = 500,000 gain

5. C
Solution:
I. Derivative asset (liability) on Dec. 31, 20x1:
(45 – 47) x 20,000 = (40,000) liability

II. Net settlement on Feb. 2, 20x1:

(45 – 44) x 20,000 = 20,000 receipt

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

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

62

8. C [(100 – 97) x 10,000 units] + 20,000 initial margin deposit =

50,000 receipt

9. B
Solution:
"Long" futures contract:
Fixed purchase price (2,800 x 200) 560,000
Purchase price at current market price (2,800 x 180) 504,000
Unfavorable – Payable to broker (56,000)

"Short" futures contract:

Fixed selling price (1,300 x 230) 299,000
Selling price at current market price (1,300 x 220) 286,000
Favorable – Receivable from broker 13,000

Net derivative liability (43,000)

10. 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.
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11. 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

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

13. C
Solution:
Analysis for Cougar:
 Cougar swaps its variable interest payment for Aggie’s fixed
interest payment; or
 Cougar pays Aggie’s fixed interest and receives variable
interest from Aggie; or
 Pay fixed; receive variable.

Pay fixed (10% x 500K) (50,000)

Receive variable (8% x 500K) 40,000
Net payment on 12/31/2003 (10,000)

14. D
Pay fixed (10% x 500K) (50,000)
Receive variable (12% x 500K) 60,000
Net receipt on 12/31/2003 10,000
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15. B
Pay fixed (10% x 500K) (50,000)
Receive variable (12% x 500K) 60,000
Net receipt on 12/31/2003 10,000
Multiply by: PV of 1 @12%, n=1 0.892857
Derivative asset - 12/31/2002 8,929
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PROBLEM 5: FOR CLASSROOM DISCUSSION

1. 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]
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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]

2. 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.
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3. 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.
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4. Solution:

Analysis:

 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 12% & 15%) 120,000 150,000
Pay 12% fixed 120,000 120,000
Net cash settlement - receipt - 30,000

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)
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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