A business plans to acquire a forward contract to hedge a monetary liability. Which of the following statements about the forward contract is true?
A)If the contract is acquired at a premium, a loss results, and if the contract is acquired at a discount, a gain results.
B)If the contract is acquired at a premium, a gain results, and if the contract is acquired at a discount, a loss results.
C)Since the contract is to hedge a monetary liability, a loss results, regardless of whether the contract is acquired at a premium or a discount.
D)Since the contract is to hedge a monetary liability, a gain results, regardless of whether the contract is acquired at a premium or a discount.

Question

Quizplus · Accepted Answer

The value of a forward contract, whether it results in a gain or a loss, depends on the difference between the contract price and the market price at settlement, not on whether it was acquired at a premium or discount. However, the statement that a loss results if the contract is acquired at a premium and a gain results if acquired at a discount is incorrect in the context of forward contracts, as their outcome depends on future market movements relative to the contract price, not the initial acquisition cost. My previous response was misleading in suggesting a direct correlation between acquisition cost (premium or discount) and outcome (gain or loss), which does not apply to forward contracts in the way described.

A Business Plans to Acquire a Forward Contract to Hedge