12_Fischer10e_SM_Module_final -

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DERIVATIVES MODULE UNDERSTANDING THE ISSUES 1. The intrinsic value of a forward contract to sell a commodity or currency is determined by comparing the spot rate/price at the date of inception of the forward to the spot rate/price at a later valuation date. At date of inception of the forward, the difference between the forward rate and spot repres- ent the total time value of the contract. Both the intrinsic value and time value per item must be multiplied by the notional amount in order to calculate the respective total val- ues. A put option has intrinsic value only if the strike price one can sell at is greater than the current spot price. The difference between these two values times the notion- al amount represents the total intrinsic value. The time value of an option is meas- ured by subtracting the intrinsic value from the total value of the option. 2. A firm commitment to sell inventory is fixed in terms of the quantity, price, and delivery terms. Therefore, if the price of the invent- ory changes prior to execution of the com- mitment, the commitment may become more or less valuable than anticipated. Keeping in mind that the price is fixed, a commitment to sell will become less valu- able if prices increase prior to execution of the commitment. This exposure to loss may be effectively hedged against through the use of a derivative instrument such as a contract or option to buy inventory. In a highly effective hedge, the loss in value on the firm commitment should be offset by the gains in value on the derivative instru- ment. 3. A cash flow hedge of a forecasted transac- tion affects both current and future operat- ing income. The effect on current operating income is represented by the change in time value of the hedging instrument. This is measured as the change in total value over time less the change in intrinsic value over time. For example, if an option’s total value increases $500 and the intrinsic value increases $700, then the time value has decreased by $200. This $200 change would be recognized in current income. Changes in the intrinsic value over time are initially recorded as a component of other comprehensive income and therefore do not currently impact operating income. However, these amounts will affect current operating income when the hedged item it- self affects current operating income. For example, if the above option hedged a fore- casted sale of inventory, changes in the in- trinsic value would not be recognized cur- rently until the hedged sale affected current income. 4. Unlike a futures contract, an option contract represents a right, rather than an obliga- tion. While the option contract requires the holder to make an initial nonrefundable cash outlay, the holder can allow the option to expire in unfavorable conditions. In the case of a futures contract, the contract must be exercised even if on unfavorable terms.
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This note was uploaded on 02/05/2010 for the course ACC 476 taught by Professor Hildy during the Spring '07 term at Lane.

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12_Fischer10e_SM_Module_final -

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