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Chapter 11 - Solution Manual

B similarly assume that seller defaults and buyer

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b. Similarly, assume that Seller defaults and Buyer must buy the 100 units it needs in the market at the prevailing market price of $1.30 per unit. To compensate Buyer for the loss incurred due to Seller’s default, Seller must pay Buyer a penalty of $30.00—that is, 100 units " ($1.30 – $1.00). 55-12Note that an asymmetrical default provision is designed to compensate the nondefaulting party for a loss incurred. The defaulting party cannot demand payment from the nondefaulting party to realize the changes in market price that would be favorable to the defaulting party if the contract were honored. 55-13Under the forward contract in the example, if Buyer defaults when the market price is $1.10, Seller will be able to sell the units of the commodity into the market at $1.10 and realize a $10.00 greater gain than it would have under the contract. In that circumstance, the defaulting Buyer is not required to pay a penalty for nonperformance to Seller, nor is Seller required to pass the $10.00 extra gain to the defaulting Buyer. 55-14Similarly, if Seller defaults when the market price is $.80, Buyer will be able to buy the units of the commodity in the market and pay $20.00 less than under the contract. In that circumstance, the defaulting Seller is not required to pay a penalty for nonperformance to Buyer, nor is Buyer required to pass the $20.00 savings on to the defaulting Seller.
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238 55-15In a forward contract with only an asymmetrical default provision, neither Buyer nor Seller can realize the benefits of changes in the price of the commodity through default on the contract. That is, Buyer cannot realize favorable changes in the intrinsic value of the forward contract except in both of the following circumstances: a. By taking delivery of the physical commodity b. In the event of default by Seller (which is an event beyond the control of Buyer). 55-16Similarly, Seller cannot realize favorable changes in the intrinsic value of the forward contract except in either of the following circumstances: a. By making delivery of the physical commodity b. In the event of default by Buyer, which is an event beyond the control of Seller. 55-17However, a pattern of having the asymmetrical default provision applied in contracts between certain counterparties would indicate the existence of a tacit agreement between those parties that the party in a loss position would always elect the default provision, thereby resulting in the understanding that there would always be net settlement. In that situation, those kinds of commodity contracts would meet the characteristic described as net settlement in paragraph 815-10-15-100. 55-18In contrast, a contract that permits only one party to elect net settlement of the contract (by default or otherwise), and thus participate in either favorable changes only or both favorable and unfavorable price changes in the underlying, meets the derivative characteristic described in paragraph 815-10-15- 83(c) and discussed in paragraph 815-10-15-100 for all parties to that contract. Such a default provision
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b Similarly assume that Seller defaults and Buyer must buy...

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