Kanesville Company is still new at using derivatives to hedge business risk. Kanesville has entered into five derivative agreements in an attempt to hedge five specific items.
The derivatives, and associated items, are briefly described here:
(a) Euro futures contract. If the U.S. dollar value of €500,000 is higher than $300,000 on July 31, Kanesville must pay the difference; if the U.S. dollar value is less than $300,000, Kanesville receives the difference. This futures contract is intended to hedge a €500,000 account payable due to be paid on July 31.
(b) Copper forward contract. If the price of copper is more than $1.10 per pound on August 31, Kanesville must pay the difference (multiplied by 100,000 pounds); if the price is less than $1.10, Kanesville receives the difference. This forward contract is intended to hedge Kanesville’s expected purchases of copper (as a raw material) for the month of August.
(c) Japanese yen futures contract. If the U.S. dollar value of ¥10 million is higher than $90,000 on July 15, Kanesville receives the difference; if the U.S. dollar value is less than $90,000, Kanesville must pay the difference. This futures contract is intended to hedge Kanesville’s expected purchase of some equipment from a Japanese company on July 15 for ¥5 million.
(d) Interest rate swap. If the interest rate on March 31 of next year is more than 12%, Kanesville receives the difference (on a principal amount of $2,000,000); if the interest rate is less than 12%, Kanesville must pay the difference. This interest rate swap is intended to hedge a $2,000,000 variable-rate loan. The loan is expected to be fully repaid this year on May 10.
(e) Call option on Williams Company stock. If the price of a share of Williams Company stock is more than $60 on September 24, Kanesville receives the difference (multiplied by 25,000 shares); if the price of the stock is less than $60, the option is worthless and will be allowed to expire. This call option is intended to hedge an investment in 25,000 shares of Williams Company stock.
Instructions: For each of these five pairs (derivative and associated item), state whether the derivative serves as an effective hedge. Explain your answer.