Option Contracts

1
Option Contracts
2
DEFINITIONS

• Call The option holder has the right to buy
  the underlying instrument at the calls
  exercise (strike) price
• Put The option holder has the right to sell
  the underlying instrument at the puts exercise
  (strike) price

3
WRITTEN OPTIONS UNDER FAS 133

• A written option is sold by an "option writer"
  who sells options collateralized by a portfolio
  of securities or other performance bonds.
  Typically a written option is more than a mere
  "right" in that it requires contractual
  performance based upon another party's right to
  force performance. The issue with most written
  options is not whether they are covered by FAS
  133 rules.  The issue is whether they will be
  allowed to be designated as cash flow hedges. 
  Written options are referred to at various points
  in FAS 133. For example, see Paragraphs 20c, 28c,
  91-92 (Example 6), 199, and 396-401.. For rules
  regarding written options see Paragraphs 396-401
  on Pages 179-181 of FAS 133.  Exposure Draft
  162-B would not allow hedge accounting for
  written options.  FAS 133 relaxed the rules for
  written options under certain circumstances
  explained in Paragraphs 396-401. 
• Note that written options may only hedge recorded
  assets and liabilities. 
• They may not be used to hedge forecasted purchase
  and sales transactions.

4
PURCHASED OPTIONS UNDER FAS 133

• Purchased options are widely used for hedging
• and present some of the biggest challenges for
• hedge accounting rules.
• The major problem is that purchased option values
  are often highly volatile relative to value
  changes in the hedged item. Traditional Delta
  effectiveness tests fail for hedge accounting for
  full value.

5
OPTION PARTICIPANTS
Call Buyer Pays premium Has the right to
buy Put Buyer Pays premium Has the right to sell
Call Seller Collects premium Has obligation
to sell, if assigned Put Seller Collects
premium Has obligation to buy, if assigned
6
IDENTIFYING OPTIONS

• Call or put
• Strike price (exercise price)
• Expiration date
• Underlying instrument

7
Option Strategies

• http//www.optionetics.com/education/strategies/st
  rategies.asp
• Bullish Strategies
• Calls
• Covered Calls
• Vertical Spread
• Bull Call Spread
• Bull Put Spread
• Bearish Strategies
• Buying Puts
• Covered Puts Bear
• Call Spread
• Bear Put Spread

8
Delta Hedging
http//biz.yahoo.com/glossary/bfglosd.html Delta
hedge where delta d(Option)/d(spot) Hedge
Ratio A dynamic hedging strategy using options
with continuous adjustment of the number of
options used, as a function of the delta of the
option. Delta neutral The value of the
portfolio is not affected by changes in the value
of the asset on which the options are written.
9
Dynamic Hedging
http//biz.yahoo.com/glossary/bfglosd.html
Dynamic hedging A strategy that involves
rebalancing hedge positions as market conditions
change a strategy that seeks to insure the value
of a portfolio using a synthetic put option.
10
SPOT/FORWARD PRICES
Price
Forward
Spot
Time
11
TIME VALUE / VOLATILITY VALUE

• Time value is the option premium less intrinsic
  value
• Intrinsic value is the beneficial difference
  between the strike price and the price of the
  underlying
• Volatility value is the option premium less the
  minimum value
• Minimum value is present value of the beneficial
  difference between the strike price and the price
  of the underlying

12
FEATURES OF OPTIONS
Option Value Intrinsic Value Time Value

• Intrinsic Value Difference between the strike
  price and the underlying price, if
  beneficial otherwise zero
• Time Value Sensitive to time and
  volatility equals zero at expiration

13
Sub-paragraph b(c) of Paragraph 63 of FAS 133

• c. If the effectiveness of a hedge with a forward
  or futures contract is assessed based on changes
  in fair value attributable to changes in spot
  prices, the change in the fair value of the
  contract related to the changes in the difference
  between the spot price and the forward or futures
  price would be excluded from the assessment of
  hedge effectiveness.

14
Sub-paragraph b(a) of Paragraph 63 of FAS 133

• a. If the effectiveness of a hedge with an option
  contract is assessed based on changes in the
  option's intrinsic value, the change in the time
  value of the contract would be excluded from the
  assessment of hedge effectiveness.

15
Sub-paragraph b(b) of Paragraph 63 of FAS 133

• b. If the effectiveness of a hedge with an option
  contract is assessed based on changes in the
  option's minimum value, that is, its intrinsic
  value plus the effect of discounting, the change
  in the volatility value of the contract would be
  excluded from the assessment of hedge
  effectiveness.

16
THE IMPACT OF VOLATILITY
A
B
Price
Price
P
P
Time
Time
17
Minimum Value
Option Value Risk Free Value Volatility Value

• If the underlying is the price of corn, then the
  minimum value of an option on corn is either zero
  or the current spot price of corn minus the
  discounted risk-free present value of the strike
  price.  In other words if the option cannot be
  exercised early, discount the present value of
  the strike price from the date of expiration and
  compare it with the current spot price.  If the
  difference is positive, this is the minimum
  value.  It can hypothetically be the minimum
  value of an American option, but in an efficient
  market the current price of an American option
  will not sell below its risk free present value.

18
INTRINSIC VALUE / MINIMUM VALUE
Option Price
Minimum Value
Strike Price
Intrinsic Value
Underlying Price
19
Minimum (Risk Free) Versus Intrinsic
ValueEuropean Call Option

• X Exercise (Strike) Price in n periods after
  current time
• P Current Price (Underlying) of Commodity
• I P-Xgt0 is the intrinsic value using the
  current spot price if the option is in the money
• M is the minimum value at the current time
• MgtI if the intrinsic value I is greater than
  zeroValue of Option exceeds minimum M due to
  volatility value

20
Minimum (Risk Free) Versus Intrinsic
ValueArbitrate for European Call Option

• X 20 Exercise (Strike) Price and Minimum Value
  M 10.741
• n 1 year with risk-free rate r 0.08
• P (Low) 10 with PV(Low) 9.259
• P 20 such that the intrinsic value now is I
  P-X 10.
• Borrow P(Low), and Buy at 20 9.25910.741
  PV(Low)M
• If the ultimate price is low at 10 after one
  year, pay off loan at P(Low)10 by selling the
  commodity at 10.
• If we also sold an option for M10.741,
  ultimately our profit would be zero from the
  stock purchase and option sale.
• If the actual option value is anything other than
  M10.741, it would be possible to arbitrage a
  risk free gain or loss.

21
INTRINSIC VALUE / MINIMUM VALUE
Option Price
Minimum Value
Strike Price
Intrinsic Value
Underlying Price
22
Minimum Versus Intrinsic ValueAmerican Call
Option

• X Exercise (Strike) Price in n periods after
  current time
• P Current Price (Underlying) of Commodity
• I P-Xgt0 is the intrinsic value using the
  current spot price if the option is in the money
• M 0 is the minimum value since option can be
  exercised at any time if the
  options value is less than intrinsic value
  I.Value of option exceeds M and I due to
  volatility value

23
Whats Wrong With the Black-Scholes ModelWhen
Valuing Options?

• The Black-Scholes Model works pretty well for
  options on stocks. It does not work well for
  interest rate and some commodity options.
• The main problem for interest rates is the
  assumption that short-term interest rates are
  constant.
• The assumption of constant variance is always a
  worry when using this model to value any type of
  option.
• The assumption of normality is always a worry
  when using this model for valuing options of any
  type.

24
LONG OPTION HEDGES

• Fair value hedges
• Mark-to-market of the option will generally be
  smaller than exposures contribution to earnings
• Cash flow hedges
• Changes in intrinsic values of options go to
  other comprehensive income to the extent
  effective
• Remaining changes in option prices goes to
  current income

Bounded by the magnitude of the exposures
price changes
25
GENERAL RECOMMENDATIONS

• For most static option hedges Exclude time
  value from hedge effectiveness considerations
• For most fair value hedges Exclude forward
  points from hedge effectiveness considerations
• For non-interest rate cash flow hedges Assess
  effectiveness based on comparisons of forward
  prices
• For options Consider the FAS Paragraph 167
  alternative for minimum value hedging.

26
THE RISK BEING HEDGED

• For non-interest rate exposures
• Entities must identify their firm-specific
  exposures as hedged items
• Differences between firm-specific prices and
  hedging instruments underlying variables will
  foster income volatility
• Pre-qualifying hedge effectiveness documentation
  is required for all cross-hedges

27
Selected IAS 39 Paragraph Excerpts

• 146.  80ltDeltalt125 Guideline.
• 147. Assessing hedge effectiveness will depend on
  its risk management strategy.
• 148. Sometimes the hedging instrument will offset
  the hedged risk only partially.
• 149. The hedge must relate to a specific
  identified and designated risk, and not merely to
  overall enterprise business risks, and must
  ultimately affect the enterprise's net profit or
  loss.
• 150. An equity method investment cannot be a
  hedged item in a fair value hedge because the
  equity method recognizes the investor's share of
  the associate's accrued net profit or loss,
  rather than fair value changes, in net profit or
  loss. If it were a hedged item, it would be
  adjusted for both fair value changes and profit
  and loss accruals - which would result in double
  counting because the fair value changes include
  the profit and loss accruals. For a similar
  reason, an investment in a consolidated
  subsidiary cannot be a hedged item in a fair
  value hedge because consolidation recognizes the
  parent's share of the subsidiary's accrued net
  profit or loss, rather than fair value changes,
  in net profit or loss. A hedge of a net
  investment in a foreign subsidiary is different.
  There is no double counting because it is a hedge
  of the foreign currency exposure, not a fair
  value hedge of the change in the value of the
  investment.
• 151. This Standard does not specify a single
  method for assessing hedge effectiveness.
• 152. In assessing the effectiveness of a hedge,
  an enterprise will generally need to consider the
  time value of money.

28
FAS Effectiveness Testing --- http//www.qrm.com/p
roducts/mb/Rmbupdate.htm

• Dollar Offset (DO) calculates the ratio of dollar
  change in profit/loss for hedge and hedged item
• Relative Dollar Offset (RDO) calculates the ratio
  of dollar change in net position to the initial
  MTM value of hedged item
• Variability Reduction Measure (VarRM) calculates
  the ratio of the squared dollar changes in net
  position to the squared dollar changes in hedged
  item
• Ordinary Least Square (OLS) measures the linear
  relationship between the dollar changes in hedged
  item and hedge. OLS calculates the coefficient of
  determination (R2) and the slope coefficient (ß)
  for effectiveness measure and accounts for the
  historical performance
• Least Absolute Deviation (LAD) is similar to OLS,
  but employs median regression analysis to
  calculate R2 and ß.

29
Regression Versus Offset Effectiveness Tests
30
The Dictionary of Financial Risk Management
defines dynamic hedging as follows ---
http//snipurl.com/DynamicHedging

• Dynamic Hedging A technique of portfolio
  insurance or position risk management in which an
  option-like return pattern is created by
  increasing or reducing the position in the
  underlying (or forwards, futures or short-term
  options in the underlying) to simulate the Delta
  change in value of an option position. For
  example, a short stock futures index position may
  be increased or decreased to create a synthetic
  put on a portfolio, producing a portfolio
  insurance-type return pattern. Dynamic hedging
  relies on liquid and reasonably continuous
  markets with low to moderate transaction costs.
  See Continuous Markets, Delta Hedge, Delta/Gamma
  Hedge, Portfolio Insurance.

31
Dynamic HedgingParagraph 144 of IAS 39 Reads as
Follows

• 144. There is normally a single fair value
  measure for a hedging instrument in its entirety,
  and the factors that cause changes in fair value
  are co-dependent. Thus a hedging relationship is
  designated by an enterprise for a hedging
  instrument in its entirety. The only exceptions
  permitted are (a) splitting the intrinsic value
  and the time value of an option and designating
  only the change in the intrinsic value of an
  option as the hedging instrument, while the
  remaining component of the option (its time
  value) is excluded and (b) splitting the interest
  element and the spot price on a forward. Those
  exceptions recognize that the intrinsic value of
  the option and the premium on the forward
  generally can be measured separately. A dynamic
  hedging strategy that assesses both the intrinsic
  and the time value of an option can qualify for
  hedge accounting.

32
New Example

• New Example Coming Up

33
Example 9, Para 162, FAS 133 Appendix BCash Flow
Hedge Using Intrinsic Value

• XYZ specified that hedge effectiveness will be
  measured based on changes in intrinsic value
• The American call option purchased at 1/1/X1 has
  a four-month term
• The call premium is 9.25, the strike rate is
  125, and the option is currently at-the-money
• See 133ex09a.xls at http//www.cs.trinity.edu/rj
  ensen/
• Also seehttp//www.trinity.edu/rjensen/caseans/In
  trinsicValue.htm

34
Example 9 from FAS 133 Paragraph 162With 100
Delta Effectiveness

• Forecasted Transaction Option
  Option
• Entry
  Time Intrinsic
• Date Value
  Value Value
• Jan. 01 125.00
  9.25 Premium 0
• 0.00 Intrinsic Value
• 9.25 Time Value
• 
  

35
Example 9 from FAS 133 Paragraph 162January 31

• Forecasted Transaction Option
  Option
• Entry
  Time Intrinsic
• Date Value
  Value Value
• Jan. 01 125.00
  9.25 0
• 
  Debit Credit Balance
• Jan. 01 Call option 9.25
  9.25
• Cash
  9.25 (9.25)
• For cash flow hedges, adjust hedging derivative
  to fair value and offset to OCI to the extent of
  hedge effectiveness.

36
Example 9 from FAS 133 Paragraph 162With 100
Delta Effectiveness

• Forecasted Transaction Option
  Option Total
• Entry
  Time Intrinsic Option
• Date Value
  Value Value Value
• Jan. 01 125.00
  9.25 Premium 0 9.25
• Jan. 31 127.25
  7.50 2.25 9.75
• 2.25 Change in Hedged
  Intrinsic Value
• 2.25 Change in Hedge Contract
  Intrinsic Value Delta 1.00 or
  100 based on intrinsic value
• Delta 0.44 44
  (9.75-9.25)/ (127.25-125.00)
• 
  

37
Example 9 from FAS 133 Paragraph 162January 31

• Forecasted Transaction Option
  Option
• Entry
  Time Intrinsic
• Date Value
  Value Value
• Jan. 01 125.00
  9.25 0
• Jan. 31 127.25
  7.50 2.25
• 
  Debit Credit Balance
• Jan. 31 Call option 0.50
  9.75
• PL 1.75
  1.75
• OCI
  2.25 (2.25)
• For cash flow hedges, adjust hedging derivative
  to fair value and offset to OCI to the extent of
  hedge effectiveness.

38
Example 9 from FAS 133 Paragraph 162February 28

• Forecasted Transaction Option
  Option
• Entry
  Time Intrinsic
• Date Value
  Value Value
• Jan. 31 127.25
  7.50 2.25
• Feb. 28 125.50
  5.50 0.50
• 
  Debit Credit Balance
• Feb. 28 OCI 1.75
  (0.50)
• PL 2.00
  3.75
  Call option 3.75 6.00
• For cash flow hedges, adjust hedging derivative
  to fair value and offset to OCI to the extent of
  hedge effectiveness.

39
Example 9 from FAS 133 Paragraph 162March 31

• Forecasted Transaction Option
  Option Total
• Entry
  Time Intrinsic Option
• Date Value
  Value Value Value
  
• Feb. 28 125.50
  5.50 0.50 6.00
• Mar. 31 124.25
  3.00 0.00 3.00
• 
  Debit Credit Balance
• Mar. 31 OCI 0.50
  0 PL
  2.50 6.25
  Call option 3.00
  3.00
• For cash flow hedges, adjust hedging derivative
  to fair value and offset to OCI to the extent of
  hedge effectiveness.

40
Example 9 from FAS 133 Paragraph 162April 30

• Forecasted Transaction Option
  Option Total
• Entry
  Time Intrinsic Option
• Date Value
  Value Value Value
• Jan. 01 125.00
  9.25 0.00 9.25
• Mar. 31 124.25
  3.00 0.00 3.00
• Apr. 30 130.75
  0.00 5.75 5.75
• 
  Debit Credit Balance
• Apr. 30 Call option 2.75
  5.75 PL
  3.00 9.25
  OCI 5.75
  5.75

41
Example 9 from FAS 133 Paragraph 162With No
Basis Adjustment Under FAS 133

• 
  Debit Credit Balance
• Apr. 30 Cash 5.75
  -3.50
• Call option
  5.75 0
• Apr. 30 OCI No basis adjustment yet
  PL No basis
  adjustment yet
• Apr. 30 Inventory 130.75
  130.75
• Cash
  130.75 -134.25 Cash -9.25
  Premium 5.75 Call Option - 130.75 -134.25

42
Example 9 from FAS 133 Paragraph 162With No
Basis Adjustment Under FAS 133

• 
  Debit Credit Balance
• May 14 Cash 234.25
  100.00
• PL (or Sales)
  234.25 -225.00
• May 14 PL (or CGS) 130.75
  - 94.25
• Inventory
  130.75 0
• May 14 OCI 5.75
  0
• PL
  5.75 -100.00
  

43
Example 9 from FAS 133 Paragraph 162With Basis
Adjustment Under IAS 39

• 
  Debit Credit
• Apr. 30 Cash 5.75
  Call option
  5.75
• Apr. 30 OCI 5.75
  PL
  5.75
• Apr. 30 Inventory 130.75
  Cash
  130.75

44
FUTURES /FORWARDS vs. OPTIONS
Futures / Forwards
Long Options
Unlimited risk/reward Limited risk/unlimited
reward No initial payment Initial payment
of premium Offsets risk and opportunity
Offsets risk/allows opportunity
45
FUTURES vs. OPTIONS
Long Calls
Futures
Long Puts
Long
Bullish
Bearish
Short
Bearish
Bullish
Speculators
unlimited gain
unlimited gain
unlimited gain
limited risk
limited risk
unlimited risk
Lock in a price
Protect against
Protect against
rising price
falling price
Hedgers
Long
Buy price
Short Sell price
(for a premium)
(for a premium)
46
OPTION VALUATION PRACTICES

• Actively traded, liquid contracts
• Use market data
• Where no market is available
• Requires marking-to-model
• Valuations will differ depending on the
  particular model used, and the inputs to the
  model
• Market values should reflect present values of
  expected future cash flows

47
Why Discounted Cash FlowDoes Not Work Well for
Valuing Options
American
Can exercise anytime up to,
and including expiration date
European
Can exercise only on
expiration date, but may be able to sell the
option at current value
Risk
Risk varies over time making DCF valuation
ineffective
48
GENERAL FEATURES OF OPTIONS ON FUTURES
Option prices move in variable proportion to
futures prices

Deep In-the-money . . . .
High proportion






(almost one-to-one) . . . .

































Low proportion
Deep Out-of-the-money
(almost zero-to-one)
49
GENERAL FEATURES OFOPTIONS ON FUTURES

• Deltas increase as options move (deeper)
  in-the-money
• Deltas are bounded between a minimum of zero and
  a maximum absolute value of one
• Time value is greatest for at-the-money options

50
MEAN AND STANDARD DEVIATION
3 S.D.
2 S.D.
1 S.D.
Mean
51
STANDARD DEVIATION

• 1 standard deviation is the range associated with
  a probability of 68.3
• 2 standard deviations is the range associated
  with a probability of 95.4
• 3 standard deviations is the range associated
  with a probability of 99.7

52
NORMAL DISTRIBUTIONS
Frequency
High volatility
Low volatility
Returns
53
STANDARD DEVIATIONAn Example
If the standard deviation is 10, that means...
Expected Price Change within 10 (1s.d.) within
20 (2s.d.) within 30 (3s.d.)
Probability 68.3 95.4 99.7
54
CALCULATING HISTORICAL VOLATILITY
?? ?
T
VOL SD

Where
VOL

Annualized volatility

SD

Standard deviation of periodic price






changes (closing prices)

T

Number of trading periods per year

55
VOLATILITY EXAMPLE
24 Annual Volatility
Daily SD (24 ? ?254) ? (24 ? 16) ? 1.5
68.3 probability that overnight change ? /-
1.5 95.4 probability that overnight change ?
/- 3.0 99.7 probability that overnight change
? /- 4.5
56
IMPLIED VOLATILITIES

• Derived from current options prices
• Reflect probability distributions of forthcoming
  price changes (i.e., the annualized standard
  deviations)
• Typically differ (significantly) from historical
  volatilities
• Generally differ across strike prices and
  maturities

57
OPTION PRICE DETERMINANTS
Premium f (IV, time, vol , r)

e

• Intrinsic value (IV)
• Time to expiration (time)
• Expected volatility (vol )
• Interest rates (r)

e
The implied volatility of a similar option is
the best input for expected volatility
58
SWAPS vs. CAPS/FLOORS
Effective
Effective
Rate
Rate
Floor
Cap
Swap
Swap
Spot
Spot
Rate
Rate
R
R
(R - P
R
)
(R P
R
)
Floor
Swap
Cap
Swap
59
BUILDING CAPS

• A cap is a series of individual options
  (caplets), each relating to a specific
  rate-setting date
• The price of a cap is the sum of caplet prices
• Option horizons (times to expiration) increase
  for successive rate-setting dates
• All else equal, longer-dated caplets are more
  expensive than shorter dated caplets
• Normal yield curves (i.e., expectations of rising
  interest rates) inflate longer dated caplets, and
  vice versa

60
FORWARD RATES
10.00
7 Strike Yield
8.00
6.00
4.00
2.00
0.00
4
8
12
16
20
24
28
32
36
40
Quarters
61
INTEREST RATE CAPS
Cap Levels
8
9
10
Premiums
2-Year
3-Year
4-Year
62
TWO YEAR COLLARBuy Caps at 8 or 9 Sell Floor
at 7.00
Collar Levels
9 / 7
8 / 7
Cap Premium
1.88
1.06
Floor Premium
0.58
0.58
Net Cost
1.30
0.48
63
TWO YEAR CORRIDORBuy Caps at 8 or 9 Sell caps
at 10.00
Corridor Levels
8 / 10
9 / 10
Long Cap Premium
1.88
1.06
Short Cap Premium
0.62
0.62
Net Cost
1.26
0.44
64
QUASI-INSURANCEExamples
Corridor Fixes outcomes within a range of prices
Collar Constrains outcomes at price extremes
Hedged
Hedged
Spot
Spot
S
S
S
S
1
1
2
2
65
New Example

• New Example Coming Up

66
CASE 7 - Cash Flow Hedge of Forecasted Treasury
Note Purchase

• On 1/1/X1, XYZ forecasts a 12/31/X1 purchase of
  100 million 5-year 6 Treasury notes to be
  classified AFS
• At 1/1/X1 the 1-year forward rate for 5-year
  Treasury notes is 6
• XYZ wants to lock in at least the 6 yield for
  the 100 million Treasury note purchase
• XYZs hedge strategy is to purchase a call option
  on 100 million of the 5-year Treasury notes that
  have a 6 1-year forward rate

67
CASE 7 - Cash Flow Hedge of ForecastedTreasury
Note Purchase

• XYZ specified that hedge effectiveness will be
  measured based on the total price change of the
  Treasury notes and the intrinsic value of the
  option (zero at 1/1/X1)
• The American call option purchased at 1/1/X1 has
  a 1-year term
• The call premium is 1.4 million, the strike rate
  is 6, and the option is currently at-the-money

68
CASE 7 - Cash Flow Hedge of ForecastedTreasury
Note Purchase

• On 1/1/X1, the following activity is recorded
• Call option asset 1,400,000
• Cash 1,400,000
• To record the option purchase

69
CASE 7 - Cash Flow Hedge of ForecastedTreasury
Note Purchase

• At 6/30/X1, the 12/31X1 forward 5-year Treasury
  rate has declined 100 basis points from 6 to 5
  and the market price is 104.376. The following
  entry is recorded to reflect the increase in the
  call options intrinsic value.
• Call option asset 4,376,000
• OCI 4,376,000
• To record the call options intrinsic value
  (assuming a price of 104.376, calculated as
  500,000 annuity received for 10 semiannual
  periods discounted at
• 5 4,376,000).

70
CASE 7 - Cash Flow Hedge of ForecastedTreasury
Note Purchase

• (continued)
• At 6/30/X1, XYZ also determines that the call
  options time value has decreased
• Earnings 800,000
• Call option asset 800,000
• To record call options time value decrease

71
CASE 7 - Cash Flow Hedge of ForecastedTreasury
Note Purchase

• At 12/31/X1, XYZ exercises the option and takes
  delivery of the Treasury notes
• Earnings 600,000
• Call option asset
  600,000
• To write off option time value balance
• Treasury notes 100,000,000
• Cash 100,000,000
• Treasury notes (premium) 4,376,000
• Call option asset 4,376,000
• To record exercise of option

72
CASE 7 - Cash Flow Hedge of ForecastedTreasury
Note Purchase

• The 12/31/X1 OCI balance of 4,376,000 is
  reclassified into earnings over the life of the
  bond. The interest method is used to calculate
  the periodic amount reclassified into earnings.
• The 4,376,000 Treasury note premium is amortized
  over the life of the bond and offsets the above
  OCI impact.
• On a cash flow and earnings basis, XYZ succeeded
  in locking in a minimum 6 return on the Treasury
  notes as if these were purchased at par.

73
CASE 7 - Cash Flow Hedge of ForecastedTreasury
Note Purchase

• XYZ demonstrates that the hedge was effective as
  follows
• Price of a 6 bond purchased in a
• 5 rate environment 104,376,000
• Less call option proceeds (4,376,000)
• Net price 100,000,000

74
CASE 7 - Cash Flow Hedge of ForecastedTreasury
Note Purchase

• If XYZ sold the 100 million bond on 6/30/X2, the
  remaining OCI balance is reclassified into
  earnings because the hedged item no longer
  affects earnings.

75
New Example

• New Example Coming Up

76
CASE 8 Fair Value Hedge of AFS Security

• XYZ owns 1,000 shares of ABC worth 100 each
  (100,000)
• XYZ wants to hedge downside price risk
• On 1/1/X1, XYZ purchases an at-the-money put
  option on 1,000 ABC shares expiring in 6 months
  exercise price is 100 option premium is 15,000
• Effectiveness is measured by comparing decreases
  in fair value of investment with intrinsic value
  of option

77
CASE 8Fair Value Hedge of AFS Security
Value at Value at Gain/ 1/1/X1
3/31/X1 (Loss) ABC Shares 100,000
98,000 ( 2,000) Put Option Intrinsic value
0 2,000 2,000 Time value
15,000 8,000 (7,000) Total
15,000 10,000 ( 5,000)
Note The time value of the option includes the
volatility value and the effects of discounting.
78
CASE 8Fair Value Hedge of AFS Security

• Journal entry at 1/1/X1
• Option Contract 15,000
• Cash 15,000
• To record payment of option premium
• No journal entry for hedged item

79
CASE 8Fair Value Hedge of AFS Security

• Journal entries at 3/31/X1
• Earnings 2,000
• Investment in ABC 2,000
• To record loss on investment in ABC
• Earnings (time value) 7,000
• Option contract 5,000
• Earnings (intrinsic value) 2,000
• To record activity up to 3/31/X1