E9.12 Fair Value Hedge of a Foreign Currency Firm Commitment: Call Options

On May 1, 2020, Greenwave Foods, a U.S. company, issued a purchase order to an Italian company for 10,000,000 in food products, to be delivered in 3 months. On that date, the spot rate was $1.20/ and the 3month forward rate was $1.203/. Greenwave guarantees the maximum U.S. dollar cost of this purchase by investing in call options on 10,000,000 at a strike price of $1.20/, costing $0.008/. Management designates the intrinsic value of the calls as a fair value hedge of a firm commitment. On June 30, Greenwave's fiscal year-end, the spot rate is $1.235/, the 1month forward rate is $1.238/ and the options sell for $0.041/. On August 1, 2020, the spot rate is $1.242/. Greenwave takes delivery of the food products, sells the options at their intrinsic value of $0.042/, and pays the Italian supplier by buying 10,000,000 in the spot market.

Required

a. Prepare entries to record the above events, including the June 30, 2020, adjusting entries. Greenwave records all income effects of inventory and related hedges in cost of goods sold.

b. Calculate the effectiveness of the hedge (change in intrinsic value of the options divided by the change in the value of the firm commitment). Why isn't the hedge perfectly effective?