Speculative Hedge Example

Turtle uses copper in its production of decorative lawn art. Turtle buys its copper from a

supplier in Canada. The cost in Canadian dollars has been constant the last few years at CD$$35$

a troy ounce. The purchase from the Canadian supplier is denominated in Canadian dollars.

On $11/1/18,$ Turtle contacts Commodity Speculators about negotiating a forward contract to buy

CD$$1,050,000$ in $6$ months at a price of $US$\mathrm{.}80/$CD$.$ The current price of a CD is $$\mathrm{.}80$ per CD$.$

Assume the following spot and forward rates for CD at these dates:

SPOT FORWARD

$11/1/18$ $$\mathrm{.}80$ $$\mathrm{.}80$

$12/31/18$ $$\mathrm{.}77$ $$\mathrm{.}78$

$3/31/19$ $$\mathrm{.}83$ $$\mathrm{.}84$

$4/20/19$ $$\mathrm{.}85$ $$\mathrm{.}85$

Commodity Speculators will account for this as a speculative hedge. This means that the

forward contract fair value must be measured at reporting dates and recorded as an asset or

liability on CS$$s balance sheet and gain or loss on CS$$s income statement.

Fair value: First question, is there a directly observable market value for this contract?

Fair value model:

$$ The model we should technically use to measure the fair value of the forward contract is

the discounted cash flow model. However, given the relatively short duration of the

contract, we will not discount the cash flows.

$$ However, we still need to estimate what we think the payment received or paid will be at

the end of the contract in order to measure the asset or liability at various points in time.

We will assume that the forward rate observed at those dates for the CD is a good

approximation of the ultimate spot rate used to determine the payment or receipt.

Entries

$11/1/18$

$12/31/18$