Log in
HomeClass Notes1,200,000CA670,000

ADMS 3595 Lecture Notes - Put Option, Treasury Stock, Retained Earnings

13 views12 pages
8 Jun 2018
School
York University
Department
Administrative Studies
Course
ADMS 3595
Professor
Yong Troy

For unlimited access to Class Notes, a Class+ subscription is required.

ADMS 3595 Solutions to Self Practice Questions
1
EXERCISE 16-4
(a) January 2, 2017
Derivatives – Financial Assets/Liabilities .........................
500
Cash .................................................................
500
(b) March 31, 2017
Derivatives – Financial Assets/Liabilities .........................
17,000
Gain
17,000
($17,500 – $500)
(c) The gain increases net income for the period by $17,000.
(d) As no information is provided as to other investments or exposures that Jackson may have,
it appears that the company has used the option for speculative purposes. Jackson
appears not to be hedging to minimize the risk of a current or future transaction.
(d) This derivative will expose the company to a price risk, as the price of the underlying is a
variable that may change the value of the option. In addition, there is a credit/counterparty
risk (the risk that the other party to the contract will not honour their side of the contract) and
a liquidity risk (the risk that Jackson will not be able to honour its side of the contract). Since
this is a purchased option, Jackson has the right but not the obligation to exercise the option.
If the option is in the money, Jackson would want to exercise it.
EXERCISE 16-6
(a) Under IFRS, this purchase commitment is an executory contract that can be settled on a
net basis by paying cash as opposed to taking delivery of the oranges. However, because
Fresh Juice fully intends to take delivery of the oranges, the contract is designated as
‘expected use’ and not accounted for as a derivative; rather, the contract is not recognized
until delivery of the oranges takes place.
Therefore, there are no journal entries required at either January 1 or January 31. A journal
entry will be recorded when Fresh Juice actually takes delivery of the oranges.
(b) If Fresh Juice does not intend to take delivery of the oranges, then the executory contract
will be viewed as a derivative because it can be settled on a net basis. Therefore, the
contract would be recorded at fair value.
Because there was no cost to enter into the contract, there would be no initial entry on
January 1.
However, the contract will be marked to market and will change as the price of oranges
change. Therefore the following journal entry will be made on January 31:
Loss (10,000 X (0.50 – 0.49)) ...............................................
100
Derivatives–Financial Assets/Liabilities
100
find more resources at oneclass.com
find more resources at oneclass.com
Unlock document

This preview shows pages 1-3 of the document.
Unlock all 12 pages and 3 million more documents.

Already have an account? Log in
ADMS 3595 Solutions to Self Practice Questions
2
(c) Under ASPE, this purchase commitment contract would not be accounted for as a
derivative because this agreement is not exchange traded. Therefore, the contract would
not be recognized until delivery of oranges takes place.
EXERCISE 16-7
(a) The derivative is considered a fixed-for-fixed derivative in an entity’s own shares as the
option stipulates that the entity will purchase (buy back) a fixed number of shares for a
fixed amount of consideration. IFRS states that this transaction would be presented as a
reduction from shareholders’ equity and not as an investment. This is, effectively, the
prospective retirement of shares (or acquisition of treasury shares, if that is permitted).
Equity – Fixed-for-fixed Derivative ...........................
250
Cash ..............................................................
250
(b) Because the option allows a choice in how the option will be settled, the instrument is a
financial asset or liability (derivative) by default under IFRS unless all possible settlement
options result in it being an equity instrument. In this case, one settlement option is the
delivery of cash. Therefore, it will be classified as a financial asset (derivative).
EXERCISE 16-8
Timing of
recognition
Measurement
Gains or Losses
1.
When fair value
fluctuates. Value at
acquisition is $nil.
PV of future cash
flows
Net Income
2.
When fuel prices
fluctuate. Value at
acquisition is $nil.
PV of future cash
flows
Net Income
3.
N/A
N/A
N/A
4.
As these are not
exchange traded
and the company
intends to take
delivery of the steel,
these are not
recognized in the
financial statements
under either ASPE
or IFRS
Not recognized
unless onerous
N/A
5.
When options are
purchased and cash
is paid
Cash paid
N/A
find more resources at oneclass.com
find more resources at oneclass.com
Unlock document

This preview shows pages 1-3 of the document.
Unlock all 12 pages and 3 million more documents.

Already have an account? Log in
ADMS 3595 Solutions to Self Practice Questions
3
6.
Initial margin is
similar to a bank
account.
Cash deposited
on margin
Net Income
7.
When shares are
issued
PV of future cash
flows
Net Income
8.
Hybrid instrument.
Warrants are written
call options, and
debt is a liability.
When debt is
issued
IFRS – debt at PV
of future cash
flows and rest to
equity
ASPE – may
allocate $0 to the
warrant or may
bifurcate the initial
amount between
debt and equity
allocating the
more easily
measurable first
with the residual
to the other
component
Net Income for
debt component
including interest
and gains/losses
upon
extinguishment
9.
Hybrid instrument –
conversion option is
a written call option
and is equity since a
fixed number of
shares will be
issued.
When debt is
issued
IFRS – debt at
PV of future cash
flows and rest to
equity
ASPE– may
allocate $0 to the
conversion
feature or may
bifurcate the initial
amount between
debt and equity
allocating the
more easily
measurable first
with the residual
to the other
component
Net Income for
debt component
including interest
and gains/losses
upon
extinguishment
find more resources at oneclass.com
find more resources at oneclass.com
Unlock document

This preview shows pages 1-3 of the document.
Unlock all 12 pages and 3 million more documents.

Already have an account? Log in

Document Summary

Derivatives financial assets/liabilities (,500 ) The gain increases net income for the period by ,000. (c) (d) as no information is provided as to other investments or exposures that jackson may have, it appears that the company has used the option for speculative purposes. Since this is a purchased option, jackson has the right but not the obligation to exercise the option. If the option is in the money, jackson would want to exercise it. Exercise 16-6 (a) under ifrs, this purchase commitment is an executory contract that can be settled on a net basis by paying cash as opposed to taking delivery of the oranges. Fresh juice fully intends to take delivery of the oranges, the contract is designated as. Expected use" and not accounted for as a derivative; rather, the contract is not recognized until delivery of the oranges takes place. (b) Therefore, there are no journal entries required at either january 1 or january 31.

Get access

Grade+
$40 USD/m
Billed monthly
Grade+
Homework Help
Study Guides
Textbook Solutions
Class Notes
Textbook Notes
Booster Class
10 Verified Answers
Class+
$30 USD/m
Billed monthly
Class+
Homework Help
Study Guides
Textbook Solutions
Class Notes
Textbook Notes
Booster Class
7 Verified Answers

Related Documents

ADMS 3595 Chapter Notes - Chapter 16: Financial Instrument, Underlying, Market Risk
raspberrymouse643
ADMS 3595 Chapter Notes -Preferred Stock, Hybrid Security, Net Income
pucewildebeest131
RSM320H1 Chapter Notes - Chapter 16: Executory Contract, Underlying, Interest Rate Risk
skytiger621

Related Questions

FINANCIAL MANAGEMENT- 14th Edition Chapter #23 - Mini Case

Assume you have just been hired as a financial analyst by Tennessee Sunshine Inc., a mid-sized Tennessee company that specializes in creating exotic sauces from imported fruits and vegetables. The firm’s CEO, Bill Stooksbury, recently returned from an industry corporate executive conference in San Francisco, and one of the sessions he attended was on the pressing need for companies to institute enterprise risk management programs. Because no one at Tennessee Sunshine is familiar with the basics of enterprise risk management, Stooksbury has asked you to prepare a brief report that the firm’s executives could use to gain at least a cursory understanding of the topics.

To begin, you gathered some outside materials on derivatives and risk management and used these materials to draft a list of pertinent questions that need to be answered. In fact, one possible approach to the paper is to use a question-and-answer format. Now that the questions have been drafted, you have to develop the answers.

a. Why might stockholders be indifferent to whether or not a firm reduces the volatility of its cash flows?

b. What are six reasons risk management might increase the value of a corporation?

c. What is COSO? How does COSO define enterprise risk management?

d. Describe the eight components of the COSO ERM framework.

e. Describe some of the risks events within the following major categories of risk:

o (1) strategy and reputation,

o (2) control and compliance,

o (3) hazards,

o (4) human resources,

o (5) operations,

o (6) technology, and

o (7) financial management.

f. What are some actions that companies can take to minimize or reduce risk exposures?

g. What are forward contracts? How can they be used to manage foreign exchange risk?

h. Describe how commodity futures markets can be used to reduce input price risk.

i. It is January, and Tennessee Sunshine is considering issuing $5 million in bonds in June to raise capital for an expansion. Currently, the firm can issue 20-year bonds with a 7% coupon (with interest paid semiannually), but interest rates are on the rise and Stooksbury is concerned that long-term interest rates might rise by as much as 1% before June. You looked online and found that June T-bond futures are trading at 111’25 . What are the risks of not hedging, and how might TS hedge this exposure? In your analysis, consider what would happen if interest rates all increased by 1% .

j. What is a swap? Suppose two firms have different credit ratings. Firm Hi can borrow fixed at 11% and floating at LIBOR + 1% . Firm Lo can borrow fixed at 11.4% and floating at LIBOR + 1.5% . Describe a floating versus fixed interest rate swap between firms Hi and Lo in which Lo also makes a “side payment” of 45 basis points to Firm L.

DOZIER INDUSTRIES (B)

Richard Rothschild, the chief financial officer of DozierIndustries, was still contemplating how best to manage the exchangerisk related to the company's new sales contract. The £1,057,500balance of the contract was due in three months on April 14, 1986,creating a long position in British pounds. Rothschild had spokenpreviously to John Gunn, an officer in the International Divisionof Southeastern National Bank, about hedging his long poundexposure. Gunn had explained two alternatives available to Dozierto reduce the exchange risk: a forward contract or a spottransaction. Either transaction would ensure that Dozier receive aset dollar value for its pound receivable, regardless of any changein the value of the pound. Given his previous analysis of theforeign exchange market, Rothschild was concerned that both ofthese hedging alternatives would lock in a profit margin below the6% he had originally anticipated for the contract. He wondered ifthere were some way to get the upside potential without all therisk.

The pound had weakened since his bid submission date on December3 (see Exhibit 1), but he was not entirelyconvinced it would continue to fall, or at least not as much as theforward rate indicated. If the future spot rate were greater thanthe current forward rate, an unhedged position could lead to again, whereas a hedged position would create an opportunity lost.Rothschild wondered if other alternatives were available, and heagain called John Gunn at the bank for advice.

Gunn explained that Rothschild could also use currency optionsto hedge against his uncertain foreign exchange exposure. Optionsprovide a means of hedging against volatility without taking aposition on expected future rates. Gunn explained that there aretwo basic varieties of options contracts: "puts" and "calls." A putgives the holder the right, but not the obligation, to sell foreigncurrency at a set exercise or "strike" price within a specifiedtime period. A call gives the holder the right to buy foreigncurrency at a set price. In comparison with a forward or futurescontract, the holder of an option does not have to transact at theagreed-upon price, but has the choice or option to do so. Gunn toldRothschild that options are complicated and increase the front endcost of hedging in comparison with a forward hedge. He saidRothschild could find the prevailing option contract prices in theWall Street Journal (see Exhibit 2).

EXHIBIT 1

HISTORICAL SPOT RATE AND FORWARD POUND IN U.S DOLLARS

DATE SPOT 3- MONTH FORWARD RATE

07/08/85 1.3640 1.3490

07/16 1.3880 1.3744

07/23 1.4090 1.3963

07/30 1.4170 1.4067

08/6 1.3405 1.3296

08/13 1.3940 1.3828

08/20 1.3900 1.3784

08/27 1.3940 1.3817

09/4 1.3665 1.3553

09/10 1.3065 1.2960

09/17 1.3330 1.3226

09/24 1.4200 1.4089

10/1 1.4120 1.4005

10/8 1.4155 1.4039

10/15 1.4120 1.4007

10/22 1.4290 1.4171

10/29 1.4390 1.4270

11/5 1.4315 1.4194

11/12 1.4158 1.4037

11/19 1.4320 1.4200

11/26 1.4750 1.4628

12/3 1.4820 1.4704

12/10 1.4338 1.4214

12/17 1.4380 1.4249

12/23 1.4245 1.4114

12/30 1.4390 1.4260

01/7/86 1.4420 1.4284

1/14/86 1.4370 1.4198

EXHIBIT 2

FOREIGN CURRENCY OPTIONS ON JANUARY 14,1986

OPTION& STRIKEPRICE CALLS-LAST PUTS-LAST

UNDERLYING CENT PERUNIT JAN. FEB.MAR. JAN. FEB. MAR.

Bpound 130 S R 13.50 S R R

144.41 135 S R 9.20 S 0.20 0.50

144.41 140 S 4.50 4.75 S 0.80 1.55

144.41 145 s 1.35 2.50 s 3.10 4.40

144.41 150 s 0.40 0.90 s r r

r- not traded s- no option offered. andLast is premium (purchase price)

Dozier Industries (B)

FOREIGN CURRENCY IPTIONS ON DECEMBER 3,1985

OPTIONS& STRIKEPRICE CALLS-LAST PUTS-LAST

UNDERLYING CENT PERUNIT DEC. JAN. MAR. DEC. JAN. MAR.

Bpound 120 29.00 S 28.95 R S R

148.86 130 19.10 R R R R R

148.86 135 13.80 R 14.60 0.05 R R

148.86 140 8.80 R 10.00 0.05 R S

148.86 145 4.00 4.50 5.70 0.20 1.05 3.20

148.86 150 0.65 1.65 3.35 R R 5.60

148.86 155 R 0.50 1.70 R R R

R- NOTTRADED S- NO OPTIONS OFFERED. LAST IS THE PREMIUM(PURCHASE PRICE)

Case B: Additional Information
1. You should treat January 14, 1986 as the date when you areperforming your analysis and acting on the analysis (hedging or nothedging).
2. To reduce risk, Dozier will take the 10% initial deposit(pounds) and sell the pounds in the spot market on Jan 14.
3. Any dollars that Dozier receives on Jan 14 are deposited in thebank for 90 days.
4. For the purpose of your calculations, you may ignore the factthat currency option contracts for the pound come in 12,500 poundincrements. However, you may discuss this limitation qualitativelyin making your recommendation (last discussion question)below.
5. None of the option contracts mature on Apr 14, 1986. Ideally,Dozier would want an option that matures on that date for thepurpose of hedging. In deciding which option maturity is best (Febor Mar), you should consider this problem and choose the maturitythat best meets Dozier’s hedging objective. First choose the optionmaturity that best meets Dozier’s objective. Then in yourcalculations below, you may treat the options as if they mature Apr14. Qualitatively, however, you should consider this maturitymismatch in making your recommendation (last discussion question)below.
6. In exhibit 2, 144.41 U.S. cents per pound refers to the spotrate for the pound on Jan 14. This is inconsistent with what isreported elsewhere in both the A and B parts of this case. Continueto use the spot rate given in part A of this case for 1/14/86. Forthe rest of the table the rows correspond to a strike price between130 cents and 150 cents per pound. The columns correspond to eithercall options or put options with either Jan, Feb, or Marchmaturities. Any entry in the table (for example 0.50 cents perpound) is the option premium. In this example, 0.50 cents per poundis the premium for a put option with a March maturity and a strikeprice of 135 cents per pound.

First read the “B” case, and then address the followingquestions:
1. Do you recommend using a call or put option to hedge theexchange rate risk? Explain.
2. Do you recommend an option with expiration in Feb. orMarch?
3. Calculate the U.S. dollar profit or loss for each possibleoutcome; there will be more than one possible outcome for eachoption. Recall that with an option, the option does not have to beexercised; the holder may choose to trade in the future spotmarket. The holder’s choice depends on the future spot rate. Note:You will do these calculations for either all of the call optionsor all of the put options and for either all of the Feb or all ofthe March options, depending on your answer to the first twoquestions above. Hint: Since Dozier’s motive is hedging, you firstcalculate the revenue in dollars that Dozier will receive for thePound receivable. Then subtract Dozier’s Costs given in Case Aexhibit 3.
4. Which option do you recommend? Explain. Note: You must nowselect one of the options with a given maturity and strikeprice.
5. Compare the option hedge to the forward hedge (in the A case)and to remaining unhedged. Which do you recommend? Explain.

6. Institutional portfolios can take advantage of what is called "portfolio margining" under the rules of the CBOE and other options exchanges. What IS portfolio margining? Choose only one answer.

A. You only pay attention to the bottom margin of the portfolio.

B. Great leverage is possible, as the intercorrelations and natural offsets (or what we call in English a "wash") are taken into consideration.

C. No margin is required, because these are not individual investors.

7. What does the symbol ^VVIX mean?

A. Apple's volatility.

B. An exchange-traded (ETF) volatility fund.

C. The implied volatility of the VIX options themselves.

8. An example of purchasing a "real" option is a company's opening of a Shanghai office, in order to have the capacity to pursue business in China.

True

False

9. A hedge fund is "short" a portfolio of VIX call options. It's "theta" is $16,788 per day. This means, barring some big market or political or terrorist event, the fund's net asset value will increase by about $16,788 per day.

True

False

10. Imagine an equity-oriented state pension fund (such as the State of Maryland Pension funds). Suppose their equity portfolio is NOT identical to the S&P 500 index. Further, suppose that due to a state budget shortfall, the year's additions to the pension fund are likely to be less than actuarially sound. Thus, the fund is becoming very risk-averse. And it needs to implement this feeling by hedging. CHOOSE THE BEST ANSWER, even though there might be more than one true answer. This is actually a question about hedge ratios. A. If the equity portfolio's beta is close to 0, then they could decide to match the overall exposure, via S&P Index futures contracts, to the fund's value. That is, # of contracts times the contract multiplier times the index would approximately equal the value of the fund.

B. If the equity portfolio's beta is close to .4, then they would have a tough time using S&P 500 contracts, so they would instead use foreign exchange contracts.

C. If the equity portfolio's beta is close to 1, then they could decide to match the overall exposure, via S&P Index futures contracts, to the fund's value. That is, # of contracts times the contract multiplier times the index would approximately equal the value of the fund.

11. Go to CMEGROUP.COM We are going to hedge ULSD https://en.wikipedia.org/wiki/Ultra-low-sulfur_diesel for a railroad, that uses ultra-light diesel fuel. Choose June 2017 as the underlying future. Let's pretend we are buying ten futures contracts. What would ten contracts cost you, using the last trade as our price? Show your math, i.e., #gallons times price per futures contract. Is this contract in contango, or normal backwardation?

12. Long options positions(long does not mean long-dated) have positive gamma, and short positions have negative gamma.

True

False

13. In valuing credit default swaps, one must estimate default probabilities. A start would be to obtain historical data for default rates from rating agencies such as Standard & Poor's. But a more complete risk profile, or risk prediction, limiting ourselves to the US market (US-based companies) would be to [pick only one choice, the best one, in your opinion]:

A. Also consider the risk of another earthquake in Japan.

B. Also consider the systematic risk associated with an economic downturn in the US, accompanied by a downturn in US stocks.

C. Also consider the possibility that Facebook options are trading at an implied volatility that is not as high as it should be, considering the lofty level of its P/E ratio.

14. A total return swap can be a form of financing vehicle to allow an investor to buy a specific bond, because: (there are two correct answers, you must pick two)

A. The payer (a financial institution) could agree to pay the bond's capital appreciation or depreciation, plus the interest payments, in return for receiving LIBOR plus some basis points.

B. The payer (a financial institution) could agree to receive the bond's capital appreciation or depreciation, plus the interest payments, in return for receiving LIBOR plus some basis points.

C. The payer retains ownership of the bond for the life of the contract.