REFERENCE: Ref.09_08
On May 1,2007,Mosby Company received an order to sell a machine to a customer in Canada at a price of 2,000,000 Mexican pesos.The machine was shipped and payment was received on March 1,2008.On May 1,2007,Mosby purchased a put option giving it the right to sell 2,000,000 pesos on March 1,2008 at a price of $190,000.Mosby properly designates the option as a fair value hedge of the peso firm commitment.The option cost $3,000 and had a fair value of $3,200 on December 31,2007.The following spot exchange rates apply: Mosby's incremental borrowing rate is 12 percent,and the present value factor for two months at a 12 percent annual rate is .9803.
-What was the net increase or decrease in cash flow from having purchased the foreign currency option to hedge this exposure to foreign exchange risk?

Question

REFERENCE: Ref.09_08
On May 1,2007,Mosby Company received an order to sell a machine to a customer in Canada at a price of 2,000,000 Mexican pesos.The machine was shipped and payment was received on March 1,2008.On May 1,2007,Mosby purchased a put option giving it the right to sell 2,000,000 pesos on March 1,2008 at a price of $190,000.Mosby properly designates the option as a fair value hedge of the peso firm commitment.The option cost $3,000 and had a fair value of $3,200 on December 31,2007.The following spot exchange rates apply:  Mosby's incremental borrowing rate is 12 percent,and the present value factor for two months at a 12 percent annual rate is .9803.
-What was the net increase or decrease in cash flow from having purchased the foreign currency option to hedge this exposure to foreign exchange risk?

Quizplus · Accepted Answer

The option was properly designated as a fair value hedge of a peso firm commitment. The option's fair value increased $200 from $3,000 ($3,200 - $3,000), which when multiplied by the 200,000 option units gives a net increase in cash flow of $600,000. The option's premium is amortized to the income statement each reporting period over the option's life, in this case, 10 months. Thus, the premium of $3,000/10 x 8 = $2,400 should be recognized as an expense in 2007, and the premium of $3,000/10 x 2 = $600 should be recognized as an expense in 2008. Therefore, the net increase in cash flow is $600,000 - $3,000 + $600 = $597,600. Since the put option was in-the-money on March 1, 2008, Mosby could have exercised the option and received $380,000 ($190,000 x 2) in exchange for 2,000,000 pesos. However, since the option was designated as a fair value hedge, it off-set the loss in value of the peso firm commitment of 2,000,000 pesos.

REFERENCE: Ref.09_08 on May 1,2007,Mosby Company Received an Order to Sell a Sell